Explanatory Memorandum(Circulated by the Treasurer, the Hon. Leslie Bury)
Notes on Clauses
This clause formally provides for the short title and citation of the Amending Act and of the Principal Act as amended.
Section 5(1A.) of the Acts Interpretation Act 1901-1966 provides that every Act shall come into operation on the twenty-eighth day after the day on which the Act receives the Royal Assent, unless the contrary intention appears in the Act.
By this clause, it is proposed that the Amending Act shall come into operation on the day on which it receives the Royal Assent. This will enable early effect to be given to the proposal for allowing deductions for interest on eligible convertible notes.
Section 5 of the Principal Act lists the Parts and Divisions into which the Act is divided. Clause 3 will effect an amendment to the list consequential upon the proposed insertion in the Principal Act of a new Division - Division 3A - relating to convertible notes.
This clause proposes an amendment to sub-paragraph (iii) of paragraph (b) of sub-section (2.) of section 44 of the Principal Act which is consequential on the proposed insertion in the Principal Act of provisions - section 82S - which will have the effect of allowing a deduction for interest in respect of eligible convertible notes.
Before section 51AB was inserted in the Principal Act in 1960, section 44(2.)(b)(iii) exempted from tax dividends which were satisfied by the issue of bonus shares and were paid out of profits from the issue of shares at a premium. Because section 51AB in effect treated convertible notes as being equivalent to shares by specifying that, like dividends on shares, interest on convertible notes was not to be an allowable deduction, a complementary amendment was made to confer on bonus share issues made out of profits from the issue of convertible notes at a premium the exemption conferred by section 44(2.)(b)(iii).
The amendment which clause 4 proposes to make to section 44(2.)(b)(iii) is designed to restore the tax position, in relation to bonus issues out of premiums arising from the issue of convertible notes, interest on which is deductible by reason of the new section 82S, to that which existed prior to the introduction of section 51AB. In effect, it is proposed that premiums on the issue of convertible notes, interest on which qualifies for deduction under section 82S, will not be available for tax-free distribution to shareholders as bonus shares. Premiums on non-eligible issues of convertible notes will, however, remain available for tax-free distribution in this way.
Sub-clause (1.) of this clause proposes the repeal of section 51AB of the Principal Act. Substitute provisions are proposed in the next succeeding clause of the Bill.
Sub-clause (2.) is designed to ensure that, notwithstanding the repeal of section 51AB, the provisions of that section will continue to apply after the commencement of this Bill in relation to interest and expenses of borrowing incurred before the commencement of this Bill in respect of a convertible note issue.
The treatment for income tax purposes of interest and expenses of borrowing incurred after the commencement of this Bill in respect of convertible notes to which section 51AB now applies will remain unchanged, except where the proposed new tests for deductibility are met in relation to convertible note issues made in the future.
By this clause, it is proposed to insert a new Division - Division 3A - in the Principal Act.
The Division will permit allowance of a deduction for interest on eligible convertible notes. Eligibility is to be dependent on the loan to which the note relates, and the terms applicable to the note issue, satisfying certain requirements specified in section 82S. For notes that do not satisfy these requirements, the Division will, by section 82R, continue the general prohibition of deductions for interest on convertible notes.
Sub-section (1.) of the proposed section 82L defines certain terms used in Division 3A.
The definition of "convertible note", and the ancillary definitions of "instrument", "issued", "issue", "loan" and "note" are designed to identify the securities to which the proposed Division 3A will apply. These definitions are used in existing section 51AB and will have the same meaning for purposes of new Division 3A as they have in the past had in that section.
The key definition is that of "convertible note". The term is to continue to mean a note relating to borrowings and indebtedness that may, directly or indirectly, be converted into, or redeemed by, the issue of shares or stock in a company, or which entitles a person to a right or option to acquire shares or stock in a company. "Convertible note" is defined in the proposed legislation to this effect.
New definitions in sub-section (1.), which are explained below, are designed to facilitate the drafting of the provisions which are to authorise the allowance of a deduction for interest incurred in respect of eligible convertible notes.
- "foreign loan" is defined to mean a loan to a company raised outside Australia in a currency other than Australian currency. The definition is necessary because, as already mentioned, in some respects the conditions proposed for deductibility of interest on convertible borrowings made overseas are different from those proposed for Australian raisings.
- "qualified person" means essentially a registered company auditor. As under company law, officers of the company and certain of their business associates are excluded from the definition of "qualified person". The term is defined for the purposes of proposed section 82T which sets out the procedure for placing a value on a share for purposes of the "conversion price" test. Where shares are not traded on an Australian stock exchange during the relevant period, e.g., in the case of unlisted shares, a valuation will need to be placed on the shares by a qualified person. The definition provides that the qualified person must be a registered company auditor, that is, a person with the necessary technical qualifications.
- "the date of offer" will mean the initial date on which a person or persons were invited in writing by a company to subscribe money to it by way of loan or to convert an earlier loan, whether the invitation is made to one person, a group of persons or the public. This definition and the next one explained ("the maturity date") are relevant to the period during which the "option to convert" must be exercisable.
- "the maturity date" is defined to mean the date by which the whole of the loan to which the convertible note relates is, under the terms applicable to the note, to be repaid, redeemed or satisfied.
- "the relevant valuation period" defines the period which will provide the basis for the ascertainment of the value of shares for the purposes of the "conversion price" test in accordance with proposed section 82T. Generally, the relevant valuation period will be the period of one month ending on the "valuation date" (see following explanation of that term). However, if, in the case of shares listed on a prescribed stock exchange, there are no sales of fully-paid shares of the class concerned during that period, the definition provides that the relevant valuation period will be the next preceding month and, if there are no such sales during that month, but sales occurred in the month before that, that earlier month will be the valuation period. (If there were no sales of listed fully-paid shares during the whole of the three months ending on the valuation date, the value of the shares will be established by valuation by a "qualified person", as at the end of the relevant period which, in this case, will be the month ending on the "valuation date".)
- "the valuation date" will mean the date that occurs two weeks before the date on which the convertible notes are offered for subscription. The valuation date is set two weeks before the date of offer to allow time for the valuation to be made and the conversion price established so that the latter can be included in a prospectus or other notice to be issued on the intended date of offer.
Sub-section (2.) repeats a provision contained in the existing section 51AB. It provides that, where two or more related instruments have, in combination, the same effect or operation as a convertible note, they are to be treated together as a convertible note for the purposes of Division 3A.
Sub-section (3.) is also a re-enactment of a provision in the existing section 51AB. It will apply where a company issues a note that does not directly entitle the holder to an issue of shares, but gives a right under a further instrument or series of instruments to obtain an issue of shares. If the overall effect of the note and the series of instruments is the same as that of a convertible note (as defined), the note and each of the instruments are to be regarded as a convertible note.
Sub-section (4.) of section 82L is a drafting measure by which a convertible note will be regarded as applying to a loan if it evidences, acknowledges or creates the loan.
Sub-section (5.) of section 82L is also a technical drafting measure. It provides that, in Division 3A, the terms applicable to a convertible note are to be treated as including terms that so apply in pursuance of, or by virtue of, a trust deed, or otherwise.
This section lays down the conditions to be met if a loan is to be treated, for the purposes of the proposed Division 3A, as a "new loan" or as an "approved replacement loan". As explained later in the notes on proposed section 82S, a deduction for interest on a convertible note will be allowable only where all other conditions are satisfied and the loan to which the note relates is a "new loan" or an "approved replacement loan" under section 82M. Broadly speaking, section 82M will have the effect that interest paid under a convertible note will be an allowable taxation deduction only if the loan to which the note applies is made by the payment of money to the company either at the time the loan is made or at the time that an earlier loan, which is converted into the loan to which the note applies, was made.
Sub-section (1.) of section 82M refers to new loans.
Paragraph (a) of the sub-section provides that, to be treated as a new loan, a loan to a company must be made, and wholly made, by money being paid to the company at the time when the loan is made. A convertible note issued as consideration for, for example, shares that are acquired under a take-over scheme will thus not come within the new provisions of section 82S.
Paragraph (b) of sub-section (1) reinforces paragraph (a) by excluding a loan made by the payment of money where, in order to enable or assist a person to make a loan to it, a company has made money or other property available to him or has arranged for another company or person to do so.
The paragraph would apply to debar deductibility of interest where, for example, in a take-over by one company of another, the offeror company arranged with the members of the company being taken over to acquire their shares for cash on the understanding that the members were to use the cash (or part of it) to make a loan to the offeror company.
Sub-section (2.) of section 82M refers to approved replacement loans. Its broad purpose is to enable convertible notes to attract interest deductibility where they are issued to fund an existing fixed-interest, fixed term borrowing.
Paragraphs (a) to (d) of sub-section (2.) specify tests to be met by an earlier loan that is converted into a loan to which a convertible note applies if the latter is to be treated as an approved replacement loan. The tests are designed to identify characteristics of an ordinary fixed-interest, fixed term borrowing.
Paragraph (a) provides that the earlier loan must be a loan that would be treated as a new loan under sub-section (1.), that is, a loan that was made wholly by the payment of money and was not of a kind excluded by paragraph (b) of sub-section (1.)
Paragraph (b) operates to exclude an earlier loan if it is evidenced, acknowledged or created by a convertible note or is a loan to which a convertible note otherwise applies.
Paragraph (c) specifies that the earlier loan must be for a fixed period while paragraph (d) specifies that it bear a fixed rate of interest.
Paragraph (e) of sub-section (2.) has the effect that if an earlier loan that meets the tests of paragraphs (a) to (d) is, wholly or partly, converted into another loan or part of another loan and, in the latter case, the balance of the other loan is made by the payment of money and would, if it had been a separate loan, have been a new loan under sub-section (1.), the other loan shall be treated as an approved replacement loan.
Section 82N is a new provision related to provisions in Division 3A dealing with the valuation of shares. These provisions refer to shares that are listed and recorded as having been sold by prescribed stock exchanges. The section provides for the prescribing, by regulation, of prescribed stock exchanges and for the regulations to declare a stock exchange to have been a prescribed stock exchange at an earlier time. This will enable the provisions of Division 3A to take effect as soon as the amendments proposed by the Bill come into operation.
It is proposed that the following stock exchanges be prescribed for purposes of the legislation -
- The Stock Exchange of Adelaide Limited;
- The Brisbane Stock Exchange;
- The Hobart Stock Exchange;
- The Stock Exchange of Melbourne;
- The Stock Exchange of Perth;
- The Sydney Stock Exchange.
This section is related to sub-paragraph (ii) of paragraph (d) of proposed section 82S(1.) which stipulates, as a condition for interest deductibility, that the terms applicable to a convertible note must not make provision for the allotting or transferring of shares to the noteholder except in pursuance of his option to convert, or except in pursuance of a right that, in accordance with this section, is an "approved right relating to the allotting or transfer of bonus shares" to the noteholder. The broad purpose of these provisions is to enable a company, without forfeiting the deduction for interest, to provide in the terms of a convertible note issue for the noteholder to have the right to participate in new share issues that might be made by the company to shareholders during the currency of the notes.
It will not, of course, be obligatory on the company to confer such participation rights on noteholders. Nor will it be a requirement for deductibility that noteholders be given participation rights in respect of every share issue that might be made during the currency of a convertible issue. The noteholder's right to participate in new issues may, under the convertible note terms, be confined, for example, to either cash or bonus share issues.
On the other hand, the terms applicable to a convertible note must not, if interest on the note is to be deductible, give noteholders a right to acquire "bonus" shares that is not also given to shareholders, or a right to acquire "bonus" shares on more favourable terms than those available to shareholders. The specific exclusion of this type of arrangement is necessary to safeguard the "conversion price" test in proposed section 82S(1.)(d)(xiii).
Sub-section (1.) of section 82P is designed to identify the kinds of share issues in which, in addition to his rights under an option to convert, a noteholder will be entitled to participate, if the company concerned so wishes. It does this by, in effect, defining what is meant by a "bonus share allotment".
A bonus share allotment will occur where a company allots shares ("bonus shares") to holders of other shares ("qualifying shares") and the allotment is made either to holders of all the qualifying shares or is made in pursuance of applications for the shares by holders of qualifying shares in circumstances where all holders of shares of the same class as the qualifying shares were invited to apply for the bonus shares.
Shares will be "bonus shares" under the sub-section whether they are made under a "rights issue", or as a bonus issue in the usual sense of that term. It will be necessary that the bonus shares all be of the same class and that qualifying shares all be of the same class, but the bonus shares and the qualifying shares do not have to be of the same class as each other.
Sub-section (2.) will apply to the situation where the noteholder's option to convert is an option to have allotted to him shares in the capital of the borrowing company or another company. Broadly stated, paragraphs (a) and (b) of sub-section (2.) in conjunction provide that, in these circumstances, if the terms of the note specify that -
- the noteholder's rights to bonus shares, in the event of an issue of such shares, are rights to bonus shares which are issued to holders of qualifying shares that are of the same class as that to which his option to convert relates; and
- the noteholder's rights to participate in the bonus issue are on terms no more favourable than those extended to existing holders of shares of the particular class,
then the noteholder's right to participate in bonus issues will not disqualify a note issue from tax deductions for interest. It will not, of course, be obligatory for the terms of a convertible note to confer this right.
Sub-section (3.) will apply to the case where the noteholder's option to convert is an option to have shares transferred to him, i.e., shares which immediately before an exercise of the option are held by another person or persons but are, on exercise of the option, to be transferred to the noteholder.
In broad terms, paragraphs (a) and (b) of sub-section (3.) combine to have the effect, in these circumstances, that where -
- the holder of the shares that are the subject of the option participates, as holder of those shares, in a qualifying bonus issue;
- the rights of the holder of shares which a noteholder has an option to have transferred to him are not, in a qualifying bonus issue, rights to participate on terms or conditions more favourable than those extended to other holders of shares of the particular class; and
- any bonus shares issued to the existing holder cannot be transferred to the noteholder otherwise than on payment by the latter of consideration equal to that, if any, paid by the former in respect of the allotment of the shares (e.g. as the amount payable on the shares in a par issue to shareholders),
This section, in effect, defines the term "class of shares" for the purposes of Division 3A.
As explained later in these notes (see notes on section 82S), the shares to be allotted or transferred to a noteholder on his exercise of the option to convert are required to belong to the same class as shares which, at a date two weeks before the note issue is offered for subscription, had been allotted by the company. This is so because the market value of these shares forms a basis for determining the "conversion price" payable on exercise of the noteholder's option to convert.
Sub-section (1.) of section 82Q treats a share as being of the same class as another share if both shares have the same nominal (or par) value and each has attached to it the same rights, including voting and dividend rights and rights as to repayment of capital on a reduction of share capital or on a winding-up of the company.
Sub-section (2.) modifies the rules in sub-section (1.) that specify which shares are to be regarded as shares of the same class. It is designed to ensure that a share that is to be allotted in pursuance of an option to convert will not be regarded as being of a different class from a share already allotted, if the only difference in the rights applicable to the respective shares is that any dividend payable in respect of the share to be allotted under the option can be less, during the period of one year after its allotment, than the dividend payable on the share already allotted.
The enactment of this section is complementary to the proposed repeal - by clause 5 of the Bill - of section 51AB of the Principal Act. The proposed section 82R will in substance re-enact the main provisions of the repealed section 51AB. Convertible notes to which the proposed section 82R applies will thus be treated in the same way for income tax purposes under Division 3A as they would have been treated if section 51AB were not repealed. The application of section 82R is, however, subject to proposed section 82S, and convertible notes which meet the tests for deductibility of interest set out in that section will be outside the scope of section 82R.
Sub-section (1.) of section 82R provides that subject, as mentioned above, to proposed section 82S, the new section will, with two exceptions, apply in relation to convertible notes issued after 15 November 1960. The two exceptions, which relate to notes issued in a transitional period after 15 November 1960, are the same as those originally provided in section 51AB and will ensure that the new section will not strike at convertible notes that have at no time been within the scope of section 51AB.
Sub-section (2.) is designed to give full effect to the two exceptions mentioned in the above notes relating to sub-section (1.). The sub-section corresponds with sub-section (4.) of section 51AB.
Sub-section (3.) is the operative provision of section 82R. It formally enacts that interest, or any payment in the nature of interest, under convertible notes to which the section applies, shall not be an allowable deduction from the company's assessable income. The sub-section corresponds with sub-section (6.) of section 51AB.
Sub-section (4.) corresponds with sub-section (7.) of section 51AB and is designed to ensure that section 82R will have its intended operation where a company pays interest indirectly, for example, by re-imbursing some other person who has met the interest charge on behalf of the company. The sub-section provides that where a person has made a payment (whether under a guarantee or otherwise) which is, in effect, a payment of interest on convertible notes, and the payment is made good by the company, the outgoing incurred by the company shall be deemed to be interest under convertible notes. The amount involved will thus be treated for income tax purposes in the same way as if the company had itself paid the interest direct to the noteholder.
Sub-section (5.) provides that section 67 of the Principal Act does not apply to expenditure incurred by a company in borrowing money by means of convertible notes to which section 82R applies. It replaces a corresponding provision in section 51AB of the Principal Act.
Under section 67 of the Principal Act, a taxpayer who has borrowed money for the purpose of producing assessable income is entitled to a deduction for expenditure incurred by him in borrowing the money. The expenditure is ordinarily deductible over the period for which the money is borrowed, or five years, whichever is the less. A deduction is not available to a company in respect of expenses incurred in raising share capital.
The practical effect of sub-section (5.) will be that, like expenses incurred in raising share capital, no deduction will be allowed for expenses incurred in borrowing money under convertible notes the interest on which is not deductible. On the other hand, expenses of borrowing under notes the interest on which is deductible by reason of the proposed new section 82S will be deductible, subject, of course, to the provisions of section 67 of the Principal Act.
Sub-section (6.) has the effect of treating interest paid on convertible notes to which section 82R applies as dividends for the purposes of calculating a private company's liability in respect of an insufficient distribution of its income. The same effect is achieved by existing sub-section (10.) of section 51AB, which this sub-section replaces.
Dividends paid by a private company within a prescribed period are deducted from the distributable income of the company in order to arrive at the undistributed amount upon which additional tax is payable. Sub-section (6.) of section 82R will ensure that a corresponding procedure is adopted in relation to interest under convertible notes to which the section applies.
Section 82S is the operative provision by which effect will be given to the proposed restoration of deductibility of interest on certain convertible notes issued after the date of Royal Assent to this Bill. It provides that section 82R, which denies deductibility of interest on notes to which that section applies, will not apply to convertible notes that meet the tests specified in section 82S.
Where the tests set out in section 82S are satisfied in relation to a convertible note issue, the company issuing the notes will, as well as qualifying for deductibility of the relevant interest, also qualify for a deduction under section 67 of the Principal Act in respect of expenses of borrowing associated with the convertible issue. If the issuing company is a private company for the purposes of the Principal Act, interest incurred on the notes (having been allowed as a deduction in determining taxable income) will not also be regarded as dividends in determining whether the company has made a distribution of its profits sufficient to eliminate additional tax on undistributed income. As explained at an earlier stage of these notes (see notes on clause 4) dividends paid in the form of bonus shares out of profits arising from the issue of convertible notes at a premium will not be exempt from tax, where the interest on the notes qualifies as a tax deduction.
In addition to setting out the basic conditions which will establish a right to deductions for interest on convertible notes, the proposed section 82S contains provisions necessary to ensure that these conditions effectively have their intended operation.
Sub-section (1.) of section 82S comprises a series of paragraphs setting out conditions to be complied with if interest paid under a convertible note issue is to be an allowable deduction from assessable income.
Paragraph (a) of sub-section (1.) provides that the loan to the company to which the note relates is to be a new loan or an approved replacement loan as specified in section 82M.
Broadly, as mentioned earlier in comments on section 82M, a new loan is a loan made wholly by the payment of money to the company at the time that the loan was made, while an approved replacement loan is a loan into which an earlier fixed-term, fixed-interest loan is converted.
Paragraph (b) of sub-section (1.) of section 82S has, by sub-paragraph (i), the effect of restricting deductions to interest on loans made to the company after the commencement of the section which, under clause 2 of the Bill, is to be the day on which Assent is given.
A further effect of paragraph (b) (by sub-paragraph (ii) of the paragraph) is to confer deductibility for interest only where the loan to which the convertible note relates is made to the company within six months after the date on which the notes are first offered for subscription.
Under tests proposed in paragraph (d) of sub-section (1.) of section 82S, a loan to the company, other than a foreign loan, must be for a period of not less than 7 years, measured from the date on which the notes relating to the loan are offered for subscription by the company. Sub-paragraph (ii) of paragraph (b) is designed to ensure that this condition is not circumvented by a company borrowing money under convertible notes a substantial time after the date of offer of the notes.
Paragraph (c) of sub-section (1.) provides that the convertible note must be issued by the company within two months after the relevant loan was made to the company. Some of the tests for deductibility of interest under convertible notes relate to the terms applicable to the notes, which may possibly not be ascertainable until the notes are actually issued. By requiring that the convertible notes be issued within two months after the loan was made, paragraph (c) ensures that the information necessary to determine the eligibility of the notes will be available. In addition, paragraph (c) - when read in conjunction with proposed paragraph (d) of sub-section (1.) - will operate to ensure that interest deductions are only allowed in relation to a loan that is raised on terms that satisfy the proposed tests for deductibility.
Paragraph (d) contains a series of tests relating to the terms applicable to convertible notes, which must be met at the time the note is issued and at all subsequent times, if the interest under the notes is to be deductible. A reference to a term or terms applicable to a convertible note is (by reason of sub-section (5.) of section 82L) to be read as including a reference to terms that apply in pursuance of or by virtue of a trust deed or otherwise.
Sub-paragraph (i) of paragraph (d) provides that the terms applicable to the note must give the noteholder an option to have shares in the capital of the company issuing the note or in the capital of another company allotted to him, or transferred to him by a person who already holds them. It also specifies that the expression "the option to convert" used elsewhere in Division 3A means the option given to the noteholder.
Sub-paragraph (ii) of paragraph (d) has three main purposes. The first is to give effect to the intention that the conversion of a loan into share capital by the allotment or transfer of shares is to take place only at the option of the noteholder. The second is to ensure that the "conversion price" test operates in the intended way and is not circumvented by, e.g., a provision in the terms of the issue conferring on the noteholder rights to an issue of additional shares on his exercise of the option to convert, thus effectively reducing the conversion price. Thirdly, the sub-paragraph will allow noteholders to participate, equally with existing shareholders, in "bonus" issues and other issues of shares made to the shareholders during the currency of the notes.
For these purposes, the sub-paragraph makes it a condition for deductibility of interest that the terms applicable to the convertible note do not make provision for the allotting or transferring of shares to the noteholder except in two cases. One of these exceptions is, of course, allotment or transfer in pursuance of the noteholder's option to convert.
The other exception may occur where the convertible note provides for the case where the company, during the currency of the borrowing, makes a "bonus" issue of shares to shareholders or makes some other issue of shares to them, e.g., a cash issue at par (see notes on section 82P). Broadly, this exception will ensure that the company may, without losing its entitlement to interest deductions, give to noteholders who have an option to take up shares of the same kind as those held by the shareholders a right to participate with the shareholders in the "bonus" or other issue. It will not be obligatory for the company to give noteholders such rights but, if it does, the rights must correspond with, or be no more favourable to the noteholders than, the rights which the shareholders have.
If, however, a noteholder who exercised his option to convert were to have a right to further shares that the relevant shareholders did not have, or a right to such shares on more favourable terms than the shareholders, interest paid under the convertible note would not qualify for deduction. Proposed sub-paragraph (x) contains a safeguarding provision that has a comparable purpose, i.e., to safeguard the "conversion price" test.
Sub-paragraph (iii) of paragraph (d) is designed to reinforce the first of the three main purposes of sub-paragraph (ii). It will operate where a loan may, otherwise than by the allotment or transfer of fully-paid shares, be converted into share capital - e.g., where the loan moneys are to be applied in paying up the amount unpaid on shares that have been issued. If the terms of a convertible note issue provide for any such conversion, interest paid under the note will not be an allowable deduction.
In other words, sub-paragraphs (ii) and (iii) in combination ensure that interest paid under a convertible note will be eligible for deductibility of interest if the conversion of the loan into share capital can only take place as a consequence of the exercise by the noteholder of an option to have shares allotted or transferred to him.
Sub-paragraph (iv) of paragraph (d) specifies that it is to be open to the noteholder to first exercise the option to convert not later than two years after the date on which the notes are offered for subscription. The sub-paragraph does not, of course, make it obligatory for it to be provided that the noteholder must exercise the option at that time.
Sub-paragraph (v) of paragraph (d) requires the option to convert, after it becomes exercisable, to remain open at least up to twelve months before the maturity date of the loan, or to a date ten years after the date of offer if that is earlier. However, the last date for exercise of the option must be not later than ten years after the date of offer, or the maturity date of the loan if that is earlier. For example, if the convertible notes are offered for subscription on a prospectus dated 1 January 1971 and the borrowing to which a convertible note relates is to mature on (say) 1 January 1978, the final date on which the option may be exercised may be the maturity date of the loan (1 January 1978) or some date no earlier than 1 January 1977, that is, the date which occurs twelve months before the maturity date. If, in the above example, the maturity date of the loan had been 1 January 1985, the option must remain open up to 1 January 1981, that is, 10 years after the date of offer, but not any longer.
Sub-paragraph (vi) provides that the option to convert must, for all practical purposes, be exercisable throughout the period from the earliest to the latest option date. This requirement will be met if the option is exercisable by the noteholder at all times during the option period or at specified times during that period occurring not more than twelve months apart.
Sub-paragraph (vii) of paragraph (d) requires that a loan, other than a foreign loan, to which a note relates is not, in whole or in part, to be repaid, redeemed or satisfied within 7 years after the date on which the notes are offered for subscription, except to the extent necessary to meet the amount payable in respect of the allotment of shares in pursuance of the exercise of the option to convert. However, eligibility for deductions will not be lost only because the terms applicable to the note include provisions for earlier repayment of the borrowing should the company fail to meet its obligations in a way that could adversely affect the security of the noteholder's investment in the company. There is no minimum-term requirement for foreign loans, or restrictions against early repayment of such loans.
By sub-paragraph (viii) of paragraph (d) it is required that the terms applicable to the note provide for a constant rate of interest to be payable in respect of the convertible loan throughout the period of the borrowing. This requirement is modified, in the case of foreign loans, by the provisions of proposed sub-section (6.) of section 82S. As explained later in the notes on that sub-section, a provision that the rate of interest on a foreign loan may be varied from time to time in line with variations in a specified overseas interest rate, will not be regarded as a breach of this test. Sub-paragraph (viii) will have the effect that the timing of the noteholder's exercise of his option to convert into share capital must not be influenced by the company varying the interest rate payable on the notes.
Sub-paragraph (ix) of paragraph (d) is complementary to the preceding sub-paragraph - sub-paragraph (viii). It will exclude from deduction interest on a convertible note issued on terms which, in the case of a loan other than a foreign loan, offer the noteholder an inducement to advance or postpone the exercise of his option to convert, or, in the case of a foreign loan, offer the noteholder an inducement to postpone the exercise of his option to convert.
Sub-paragraph (x) is complementary to the other basic tests and requires that the amount which the noteholder is entitled to receive with respect to the repayment, redemption or satisfaction of the loan is not, under the terms applicable to the note, to vary according to whether or not he exercises the option to convert. For example, the terms of an issue of convertible notes may not, if interest on the notes is to be deductible, be such as would be effective to give the noteholder an additional cash benefit on the termination of the loan only if he exercises the option to convert. (Sub-paragraph (ii), in part, deals with the provision of additional benefits to the noteholder in the form of rights to further shares.)
Sub-paragraph (xi) of paragraph (d) is related to the test specified in sub-paragraph (v) concerning the times at which the option to convert may be exercised and, also, to the "conversion price" test. The sub-paragraph requires that the shares which, under the terms of the issue, are to be allotted or transferred upon the exercise of the option to convert are to be so allotted or transferred within two months after the exercise of the option and are also to be fully-paid shares of the same class as shares that, no later than two weeks before the offer of the notes for subscription, had been both allotted and fully paid-up.
The requirement that shares be allotted or transferred within two months of the exercise of the option to convert is designed to make effective the basic concept of the legislation that the choice of the time to convert a loan into share capital is to rest with the noteholder, and not with the borrowing company.
As the "conversion price" is, as already mentioned, to be related to shares in a company that have been allotted and fully-paid at the time of an offer of notes, the provisions of sub-paragraph (xi) also necessarily provide that the option to convert relate only to fully-paid shares of the same class as fully-paid shares that have been allotted.
Sub-paragraph (xii) of paragraph (d) is a measure designed to ensure that the "conversion price" test has its intended practical operation. The sub-paragraph provides that the terms of issue are not to include any provision for shares allotted or transferred, in consequence of an exercise of the option to convert, to be changed or converted, after allotment or transfer, into shares of a different class. It further provides that the terms of issue are not to provide for the allotment or transfer of shares which, under the company's memorandum and articles, may be changed or converted into shares of another class.
In the absence of such a provision, the value of shares at the valuation date could be determined on the basis of the rights, etc., attached to them at that time although, after allotment or transfer and change into a different class, they would have entirely different characteristics which, if they had existed at the valuation date, would have affected the value then.
It is to be noted, however, that deductibility of interest will not be affected by appropriate provision against the event that shares which are the subject of the option to convert are, during the currency of the loan, changed or converted into shares of a different class merely as the result of a consolidation or sub-division of the share capital of the company.
Sub-paragraph (xiii) of paragraph (d) contains the minimum "conversion price" test to which reference has already been made in these notes. Sub-paragraph (xi) and the proposed sections 82Q and 82T (see notes on those provisions) are also relevant.
To satisfy sub-paragraph (xiii) the amount payable by a noteholder on his exercise of the option to convert must, under the terms applicable to the issue, be no less than the minimum amount specified in the sub-paragraph. In effect, this amount is the greater of -
- the par value of a fully-paid share of the class of shares in which the share to be allotted or transferred on conversion is or will be included; and
- 90 per cent of the amount which, for the purposes of the section, is the market value (as determined under section 82T) at the valuation date of a fully-paid share of that class.
It has been explained that the valuation date is the date which occurs two weeks before the date on which the notes are offered for subscription. It has also been explained - in relation to sub-paragraph (xi) - that the option to convert is required to be related to a class of shares allotted and fully-paid up at least two weeks before the date of offer of the notes. What constitutes a "class of shares" for the purposes of Division 3A has been explained in the notes on the proposed section 82Q.
Sub-paragraph (xiii) also requires that, under the terms of issue, the amount payable by a noteholder in respect of the allotment or transfer of a share on the exercise of his option is to be paid no later than one month after the allotment or transfer.
Sub-section (2.) and sub-section (3.) of section 82S reinforce the basic tests for deductibility of interest set out in sub-section (1.) of the section. The provisions concern cases where the terms of a convertible note issue initially satisfy the requirements of the section but, through a subsequent departure from those terms, the requirements are no longer met.
Sub-section (2.) deals with cases where a convertible borrowing is repaid, in whole or part, before the maturity date, i.e., the date by which the loan is to be fully repaid. Because there is no minimum borrowing period for foreign loans, it will not apply to such loans. Nor will it apply where repayment of the loan is made in accordance with the terms of the convertible note issue, or by reason of a compromise or arrangement approved by a court.
In cases to which sub-section (2.) applies, sub-section (1.) of section 82S will cease to have effect, thus bringing about termination of the allowance of deductions for convertible note interest. Moreover, as will now be explained, sub-section (3.) will come into operation.
Sub-section (3.) of section 82S is directed to two situations, one of which has been noted in the notes on sub-section (2.). The other situation occurs where the terms of a convertible note issue initially satisfy the requirements of the section but, through a subsequent change in those terms, the requirements are no longer met. If the change in terms occurs otherwise than by reason of a compromise or arrangement approved by a court, sub-section (1.) of the section is to be deemed never to have had effect in relation to the note.
A consequence of section 82S ceasing to have effect, and being deemed never to have had effect, in relation to a convertible note is that section 82R will be treated as having always applied, with the result that all interest incurred under the convertible note will be disqualified from deduction. Further consequences will be that under sub-section (5.) of section 82R, a deduction will not be allowable for borrowing expenses of the particular note issue and the interest will be deductible for undistributed profits tax purposes in the case of a private company. Any premium received on the issue of the convertible notes would also then come within section 44(2.)(b)(iii) of the Principal Act - see notes on clause 4.
By clause 7 of the Bill, it is proposed to amend section 170 of the Principal Act to authorise the re-opening of assessments for the purpose of giving effect to the provisions of sub-section (3.) of section 82S, that is, for the purpose of disallowing in appropriate circumstances deductions previously allowed to the company in respect of convertible note interest and to give effect to the further consequences referred to.
As already indicated, sub-section (3.) will not operate to withdraw a deduction for interest that has previously been paid in cases where a change in the terms of a convertible note issue occurs by reason of a compromise or arrangement approved by a court. In these cases interest that is incurred after the change will not be an allowable deduction from income if the effect of the court's order is that the various tests of section 82S are no longer satisfied.
Sub-section (4.) of section 82S relates to a situation where the holder of a convertible note is able, whilst still retaining his interest in the indebtedness to which the note relates, to sell or otherwise dispose of his option to take up shares. The sub-section deals with cases in which the noteholder makes such a disposal so that, by reason of his assignment of the option to convert, the option becomes exercisable by a person other than the holder or owner of the note.
In these circumstances sub-section (4.), in effect, deems the holder or owner to have retained the option to convert and thus ensures that income tax deductions for interest under the note will not be lost because, technically, the holder or owner of the note no longer himself has an option to take up shares in the company.
Sub-section (5.) of section 82S is directed at special arrangements made by the company or its directors to depress, for purposes of a convertible note issue, the "conversion price" to be paid by a noteholder on the exercise of his option to convert.
It has the effect that deductions for interest paid under a convertible note are not to be allowable where the company issuing the note, or a director of it, adopts, in connection with the note issue, a course of action that has the effect of reducing below what it otherwise would have been the minimum conversion price required by sub-paragraph (xiii) of sub-section (1.)(d) of section 82S.
Sub-section (6.) of section 82S modifies the test specified in sub-paragraph (viii) of paragraph (d) of sub-section (1.) of the section as it applies to foreign loans. Sub-paragraph (viii) provides that, subject to this sub-section, the terms applicable to a convertible note must not provide for the rate of interest to vary during the period of the loan.
This sub-section means that, in certain circumstances, the inclusion of an appropriate term in a convertible note applicable to a foreign loan to the effect that the rate of interest may be varied from time to time, will not result in the failure of the convertible note to satisfy the basic test that the rate of interest may not vary. In effect, the terms of a convertible note applicable to a foreign loan will not be regarded as failing to satisfy this test if they are such that the rate of interest may be varied only by reference to movements in a specified interest rate in a specified overseas market, and that a variation in the rate does not have retrospective effect.
Sub-section (7.) of section 82S deals with a similar situation to that dealt with by sub-section (2.) of section 82Q. It will modify the operation of sub-paragraph (ix) of paragraph (d) of sub-section (1.) of the section by providing that an otherwise eligible convertible note will not be outside the scope of the new provisions merely because any dividend entitlement of the holder of a share issued in pursuance of the exercise of an option to convert will, or may, during the first twelve months after allotment, vary because the allotment occurs at a time in a year that makes it appropriate to pay less than a full year's dividend on the share.
This section provides the bases on which the value of a share, as at a "valuation date" occurring two weeks before a convertible note issue is offered for subscription, is to be determined for purposes of section 82S.
Under the "conversion price" test set out in section 82S(1.)(d)(xiii) it will be a condition for deductibility of interest paid under a convertible note that the amount to be paid for a fully-paid share that is allotted or transferred in pursuance of the exercise of an option to convert is 90 per cent of the market value of an equivalent fully-paid share as at the relevant valuation date or the nominal (par) value of that share, whichever is the greater. For this purpose section 82T provides two different bases of valuation. However, both are designed to achieve the same result, that is, to establish a reasonably accurate assessment of the worth of an equivalent fully-paid share at the time the convertible notes are offered for subscription.
Paragraph (a) of sub-section (1.) sets out the basis on which the value at the valuation date of a fully-paid share that is listed and traded on a "prescribed stock exchange" is to be determined. The paragraph provides that the value as at the valuation date of a fully-paid share that, during a preceding valuation period of one month (see earlier notes on page 8 which explain how this period is determined), was listed and traded on a prescribed stock exchange or exchanges is to be, in effect, the weighted average price at which fully-paid shares of that class were traded on 'change during the valuation period. This is to be ascertained by dividing the total consideration paid or payable in respect of recorded sales of those shares during the relevant valuation period by the total number of shares involved in those sales.
The names of the stock exchanges which it is proposed to prescribe for the purposes of these provisions are set out in the notes dealing with proposed section 82N. Sales recorded by other stock exchanges, for example, by overseas stock exchanges, are to be ignored in these calculations. If the relevant shares are listed and traded on two or more prescribed stock exchanges in Australia during the relevant valuation period, the average price is to be calculated by reference to the total sales of the relevant shares recorded by those stock exchanges.
Paragraph (b) of sub-section (1.) establishes the basis for placing a value on a fully-paid share in a case where fully-paid shares of that class were not listed and traded on a prescribed stock exchange during the valuation period. It provides that the value of the share is to be taken as the amount that a "qualified person" (i.e., a registered company auditor) certifies would be expected to be the price paid for the share if it were sold on the valuation date. The price must be the price which the auditor considers, on a true and fair view of the state of the company's affairs, would be expected to be agreed upon by a willing but not anxious seller to a willing but not anxious buyer in a sale at the valuation date.
Paragraph (b) also specifies that where shares of a relevant class are not listed on a prescribed stock exchange, the qualified person is to determine the value of the relevant share on the assumption that the constituent documents of the company satisfy requirements for listing on a prescribed stock exchange.
Sub-section (2.) of section 82T provides for the imposition of a monetary penalty where, in a certificate of the value of shares, a qualified person wilfully makes a statement which is false in a material particular, knowing the statement to be false. The penalty provided is $1,000.
This clause will give additional authority to the Commissioner of Taxation to re-open an assessment for the purpose of giving effect to the new provisions being inserted in the law by this Bill.
Section 170 of the Principal Act governs the general powers of the Commissioner to amend income tax assessments. Sub-section (10.) of the section provides that nothing in the section is to prevent the amendment of an assessment in order to give effect to certain provisions of the Principal Act. By this clause sub-section (3.) of section 82S will be included in the provisions to which sub-section (10.) of section 170 applies.
As explained in the notes on proposed section 82S, sub-section (3.) of that section provides that where, in certain circumstances, a convertible note issue ceases to satisfy the tests on which the deduction for interest depends, the interest shall be deemed never to have been deductible. To give effect to this provision in cases where assessments have already been made allowing a deduction for interest paid before the note issue ceased to satisfy the relevant tests, it will be necessary to amend the earlier assessments to disallow the deductions previously allowed. The insertion of the reference to sub-section (3.) of section 82S in section 170 will provide the necessary authority for the Commissioner to do this. It will also provide authority, in a case where interest becomes non-deductible, for amendment of assessments to treat the interest as dividends for the purposes of additional tax on the undistributed income of a private company.