Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 1 - Overview of the debt/equity rules
1.1 This chapter provides an overview of the debt/equity rules, which provide what constitutes equity in a company and what constitutes debt. Consequently, it explains how the debt/equity borderline is drawn for tax purposes.
1.2 The side of the debt/equity borderline that an interest in a company lies on is relevant for the purposes of determining the tax treatment of a return on the interest (i.e. whether it may be frankable or may be deductible). The definition of debt also constitutes a key component of the proposed thin capitalisation regime since it is used to determine what deductions may be disallowed.
1.3 Chapter 2 explains the operation of the debt/equity test. Chapter 3 sets out where the new debt and equity definitions are used in the income tax law. Chapter 4 explains the mechanics of the operation of the non-share capital account of a company and Chapter 5 contains the regulation impact statement.
1.4 The income tax law provides a tax treatment of returns to the shareholders of a company which differs from the tax treatment of returns to its creditors (debt holders).
1.5 Shareholders of a company receive dividends - which may be franked (i.e. they may carry imputation credits representing underlying company tax which may be used to reduce the shareholders tax) but which are not deductible to the company making the dividend. By paying franked dividends a company can ensure that, for the most part, its profits are ultimately taxed at its shareholders marginal tax rates. Creditors, on the other hand, receive returns which cannot be franked but which are usually deductible to the company.
1.6 This differential tax treatment is fundamental to the tax law. It recognises the fundamental difference between the equity holders of a company, who take on the risks associated with investing in the activities of the entity, and its creditors, who, as far as possible, avoid exposure to that risk. In recognising this fundamental difference, it is essential that the tax law draws the borderline separating the 2 (the debt/equity border) in such a way that the legal form of an interest cannot be used to result in a characterisation at odds with its economic substance.
1.7 A mischaracterisation of a debt interest as an equity interest can result in the inappropriate franking of debt-like returns (see Example 2.2), or companies circumventing the thin capitalisation measures. On the other hand, mischaracterising an equity interest as debt could allow inappropriate tax deductions for the issuer through so-called deductible equity (see Example 2.3). In other words, mischaracterisation could result in frankable returns being made to creditors of an entity and deductible returns to its equity holders. This would undermine the well-established distinction between the 2 types of returns and would expose the revenue to a significant risk of erosion.
1.8 Although the distinction between debt and equity is well established, the means for distinguishing between the 2 is not coherent or necessarily appropriate under the current law. A mischaracterisation of certain interests can therefore occur. For example, the current thin capitalisation provisions rely on a concept of debt that is based more on legal form than economic substance. This concept lacks the ability to deal with innovative financial arrangements. Consequently, certain arrangements that constitute in-substance debt (including synthetic and embedded debt) may result in a different tax outcome for thin capitalisation purposes than more conventional, but economically equivalent, debt arrangements.
1.9 Under the new law, the test for distinguishing debt interests from equity interests focuses on a single organising principle - the effective obligation of an issuer to return to the investor an amount at least equal to the amount invested. This test seeks to minimise uncertainty and provide a more coherent, substance-based test which is less reliant on the legal form of a particular arrangement. It provides greater certainty, coherence and simplicity than is attainable under the current law.
1.10 Part 3-5 of the ITAA 1997 provides that, for certain purposes of the income tax law (including the thin capitalisation provisions and the taxation of returns on interests in companies), equity interests in a company are those that are listed as such, unless they constitute debtinterests. Those listed are:
- interests providing returns contingent on economic performance, or at the discretion of the company; and
- interests that may or will convert into such interests or shares.
1.11 An interest in a company is a debt interest (i.e. satisfies the debt test) if, at the time of its issue, there is a scheme that is a financing arrangement under which the company has an effectively non-contingent obligation to pay an amount (or the total of several amounts) to the holder of the interest at least equal to its issue price. If the term of the interest is 10 years or less, the amount to be paid to the holder must equal or exceed the issue price in nominal value terms. If the term is greater than 10 years, the amount to be paid to the holder must equal or exceed the issue price in present value terms.
1.12 The holder of an equity interest in a company is an equity holder in the company. If an equity interest is not a share in legal form then it is called a non-share equity interest. Both shareholders and holders of non-share equity interests may be paid frankable dividends by the company.
1.13 For the purposes of determining the taxation treatment of returns (including for imputation purposes), equity interests in a company are, except in certain specified respects, treated in the same way for tax purposes irrespective of whether they are shares or non-share equity interests. To facilitate this, companies maintain a non-share capital account in relation to their issued non-share equity interests, which serves the same purpose as a share capital account in relation to shares.
1.14 The new law permits specified aspects of the new tests and definitions to be supplemented or modified in certain respects by regulation. This is to promote certainty and facilitate the categorisation of debt/equity hybrids (i.e. interests that have both debt and equity characteristics) as either debt or equity by providing guidance on how to give effect to certain aspects of the law. The regulations will not be used to alter the operation of the new law in a way inconsistent with, or not envisaged by, the objects of the provisions contained in this bill. Nor will they be used without regard to the legitimate expectations of taxpayers that any changes to the effect of the debt/equity tests should not unfairly prejudice transactions already entered into.
|New law||Current law|
|There is an extended definition of equity based on economic substance (broadly speaking, interests that raise finance and provide returns contingent on the economic performance of a company constitute equity, subject to the debt test).||Equity is limited to shares in a company.|
|There is an extended definition of dividend to encompass both dividends on shares as well as most distributions on non-share equity interests (i.e. interests which fall within the extended definition of equity).||Dividends are limited to profit distributions on shares. Non-share equity interests cannot provide frankable dividends.|
|Non-share dividends paid on equity interests issued by certain permanent establishments (branches) of Australian ADIs are, subject to conditions, to be unfrankable.||There is no equivalent rule in the existing law.|
|Debt interests are identified by reference to a single organising principle - the effective obligation of the issuer of a debt interest to return an amount at least equal to the issue price. This provides greater certainty and coherence than the current law.||The identification of debt capital, or certain other types of debt, turns on the concept of interest payments, which lacks certainty and whose determination is influenced more by legal form than economic substance.|
|For thin capitalisation purposes, debt deductions include the cost of debt capital, which incorporates interest and amounts that function as interest. This provides greater clarity and coherence than the current law.||The focus of the current thin capitalisation provisions is on the concept of interest, whose determination may be influenced more by legal form than economic substance.|
1.15 The debt/equity rules will apply from 1 July 2001 subject to certain transitional rules. Details of the application and transitional provisions are discussed in Chapter 2.