House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 2 - Debt/equity test

Outline of chapter

2.1 This chapter explains the operation of the debt/equity test. The explanation of the new law is divided into 2 sections:

•

the first section addresses the equity component of the test, including what constitutes a frankable distribution on equity interests that are not shares; and

•

the second section explains what interests are debt interests.

Detailed explanation of new law

Company equity

2.2 Division 974 of the ITAA 1997, which is inserted by this bill, provides the new rules governing what is an equity interest for tax purposes. The rules identify those interests in a company which, like ordinary shares, can support frankable (as opposed to deductible) returns. The new rules classify an interest in a company as equity or debt according to the economic substance of the rights and obligations of an arrangement rather than its mere legal form in a more comprehensive way than the current law. Relevant to the classification is the pricing, terms and conditions of the arrangement under which the interest is issued. This limits the ability of taxpayers to have returns on an interest artificially categorised as frankable or deductible to best suit the tax profiles of the issuer and the holder so as to create undesirable tax arbitrage.

2.3 To gain a comprehensive understanding of the new debt/equity rules it is necessary to understand why it matters whether an interest in a company is categorised as debt or equity. If taxpayers could choose the categorisation - by structuring the instruments legal form and without regard to the substance or nature of the arrangement - it would be at the expense of the revenue, as Examples 2.1, 2.2 and 2.3 illustrate. The new rules attempt to tax interests according to their nature rather than facilitating the manipulation of tax treatments on the basis of the tax profiles of the parties to the transaction. Without this substantive approach, tax entities could issue instruments that are identical in nature but frankable or not to suit the circumstances of the parties, at the expense of the revenue.

Example 2.1: The different tax results of debt and equity

The practical effect of the difference in tax treatment between distributions made by a company to its equity holders and other returns paid by a company (e.g. interest paid to a creditor) can be illustrated by a consideration of the different tax results that arise when $100 of assessable income is derived by a company and then paid either as a frankable distribution or as interest on a loan. The company tax rate is assumed to be 30%.

If paid as a frankable distribution, the company pays $30 tax and pays a fully franked dividend of $70 (the after-tax amount); the $30 tax paid by the company may be imputed to the recipient of the dividend.

If paid as interest, the company could distribute the full $100 without paying tax (the $100 assessable income being offset by a $100 deduction); the recipient of the interest would then be liable to tax on the full amount.

If the recipient is a taxable resident, the $100 derived by the company is effectively taxed at the recipients marginal tax rate in both cases (in the franked dividend case, the tax already paid by the company is imputed to the recipient).

However, if the recipient is a non-resident or a tax exempt unable to benefit from refundable imputation credits, the $100 is taxed at the company tax rate if it is distributed as a franked dividend. On the other hand, it is usually tax exempt if it is paid as interest to such recipients, and interest withholding tax may not be payable (because of an exemption granted under section 128F of the ITAA 1936, for example). Even if interest withholding tax is payable, it is subject to a lower rate of tax than equity.

Example 2.2: Artificial categorisation of debt as equity

A tax loss company (for whom an interest deduction is of no immediate value) with surplus franking credits, or a company with surplus franking credits seeking to lower its cost of capital or strengthen its shareholders equity base or gearing ratios, might seek to issue an equity interest that is debt-like. The purpose of this would be to compensate the investor with franked (and therefore rebatable) payments, notwithstanding that the payments are in substance interest. This would minimise the wastage of franking credits in the companys franking account that would occur as a result of the companys normal dividend policy, where the wastage would otherwise reduce the revenue cost of the imputation system.

Example 2.3: Artificial categorisation of equity as debt

A company might seek to stream a limited supply of franking credits to taxpayers best able to use them by issuing franked dividend-paying shares to Australian residents and other financial instruments to non-residents which provide economically equivalent, but non-dividend and unfranked returns, that are deductible in the companys hands.

2.4 The new debt/equity rules are framed against this background of the different tax effects that can arise from the taxation of debt and equity.

What is an equity interest in a company?

Only financing arrangements can be equity interests

2.5 The threshold question in determining whether a particular interest in a company (other than a share) is an equity interest is whether the relevant scheme giving rise to the interest is a financing arrangement. If it is not, the interest cannot be an equity interest; nor can it be a debt interest. Shares in a company do not have to satisfy this threshold question as they are inherently capital-raising instruments. [Schedule 1, item 34, subsection 974-75(2)]

What is a financing arrangement?

2.6 A financing arrangement is a scheme entered into or undertaken to raise finance for a company or a connected entity (or to fund another financing arrangement). (The use of the word scheme in this and other provisions explained in this chapter picks up the broad definition of that term in subsection 995(1) of the ITAA 1997 so that, for example, it encompasses unilateral arrangements: it is not of itself intended to imply that the relevant arrangement constitutes a tax avoidance scheme.) [Schedule 1, item 34, section 974-130]

2.7 The raising of finance generally entails a contribution to the capital of an entity, whether by way of money, property or services, in respect of which a return is paid by the entity, be it contingent (connoting equity) or non-contingent (connoting debt). It is important, however, to consider all the relevant circumstances and features of a particular arrangement to determine whether, in substance, it is appropriately characterised as a financing arrangement or not. In this regard, the intentions of the parties to the arrangement may be relevant, but are not determinative.

2.8 In the vast majority of cases it is readily apparent whether a particular arrangement constitutes the raising of finance. The issuing of a debt/equity hybrid instrument, whether in consideration for money (as would usually be the case), property or the provision of services, would, for example, constitute a financing arrangement. Conversely, a financing arrangement is not created from a contract for personal services entered into in the ordinary course of business where, in consideration for the provision of services, the employer provides a return in the form of salary commensurate with the value of the services provided. This is the case even if there is some delay between the provision of services and the payment of the salary, as occurs when, for example, an employer provides long service leave payments in recognition of services provided several years before. Another example of a scheme that is generally not entered into or undertaken to raise finance is a derivative that is used solely for managing financial risk. [Schedule 1, item 34, subsection 974-130(3)]

2.9 However, the example of an employment contract demonstrates how important it is to consider all the relevant circumstances and features of a particular arrangement to determine whether, in substance, it is appropriately characterised as a financing arrangement or not. This is because in certain, albeit unusual, circumstances an employment contract may constitute a financing arrangement, as Example 2.4 shows. The example illustrates an exception to the general rule that employment contracts do not constitute financing arrangements.

Example 2.4: An employment contract that is a financing arrangement

A company issues shares to all the members of a family except one, who is instead employed by the company for a salary contingent on profits of the company. The calculation of the salary is such that the employee receives a return equivalent to that of the other family members on their shares (increased to reflect the value of the services provided).

In these unusual circumstances the employment contract would constitute a financing arrangement because the employee is effectively funding the company by providing services instead of money. The employment contract is a substitute for shares in the company.

2.10 Some schemes are explicitly excluded from being financing arrangements. Two excluded schemes, which are relevant to the definition of equity, are schemes for the payment of royalties within the meaning of the ITAA 1936, and life insurance or general insurance contracts. [Schedule 1, item 34, subsection 974-130(4)]

2.11 Because a financing arrangement may be funded by another scheme, schemes that fund other schemes that are themselves financing arrangements will also be financing arrangements. An example is an arrangement between dual listed companies under which profits are transferred between the 2 companies in certain situations to enable the transferee to pay a dividend on its shares. In this case the profit-sharing arrangement funds the financing arrangement constituted by the shares in the transferee company and is therefore a financing arrangement itself. [Schedule 1, item 34, paragraph 974-130(1)(b)]

2.12 The following discussion of equity interests in a company relates to schemes that constitute financing arrangements.

Debt interests are not equity interests

2.13 In determining whether an interest in a company is an equity interest it is important to note that interests that, at the time of their issue (or at certain other times involving a material change: see paragraphs 2.129 to 2.134), are debt interests (or are part of a larger interest that constitute debt interests) will not be equity interests. For example, a share in a company, which would ordinarily be an equity interest, is not an equity interest if it constitutes a debt interest at the time of its issue (debt interests are explained in paragraphs 2.124 to 2.209). [Schedule 1, item 34, paragraph 974-70(1)(b)]

2.14 In applying this carve-out debt test to a converting or convertible interest (see paragraphs 2.37 to 2.40) the interest into which it converts is taken to be a new interest. Therefore, for example, the fact that a convertible preference share may be a debt interest at the time of its issue does not prevent the shares into which it converts being equity interests if those shares themselves are not debt interests. [Schedule 1, item 34, section 974-100]

2.15 In addition, there is an exception to the carve-out in relation to non-arms length arrangements (explained in paragraphs 2.61 to 2.66), and in relation to equity interests arising from certain schemes that fund returns through connected entities (see paragraphs 2.50 to 2.58).

2.16 Shares that satisfy the debt test (e.g. compulsorily redeemable preference shares) are still shares for the purposes of the income tax law and returns on them are still dividends. However, those dividends generally receive a different tax treatment from dividends on shares that do not satisfy the debt test. For example they are not frankable. To facilitate this different tax treatment, shares that satisfy the debt test are called non-equity shares. [Schedule 1, item 39, definition of non-equity share in subsection6(1)]

General test for determining whether a scheme gives rise to an equity interest

2.17 To better reflect the economic substance of particular transactions a holistic approach is adopted by the debt/equity tests. Under this approach it is necessary to look not at single transactions but at schemes, or a number of related schemes, comprising those transactions. If a particular scheme, or a number of related schemes, gives rise to an interest set out in the table in subsection 974-75(1) then that interest is an equity interest in a company, unless it, or a larger interest of which it is a part, satisfies the debt test. If the scheme or schemes do satisfy the debt test the interest will not be an equity interest even though it would have been if looked at in isolation rather than as part of the scheme or schemes. [Schedule 1, item 34, subsection 974-70(1)]

2.18 The holder of an equity interest in a company is an equity holder in the company [Schedule 2, item 8, definition of equity holder in subsection 995-1(1)] . If returns from the interest (not being a share) are payable to more than one entity, each entity is an equity holder in the company [Schedule 1, item 34, subsection 974-95(4)] . (The exception relating to shares prevents the new debt/equity rules affecting the existing law in relation to shares.)

2.19 A consequence of being an equity interest is that the whole of a distribution made in relation to the interest may be frankable. For simplicity reasons, there is no general bifurcation of a distribution on an equity interest into a frankable component and a non-frankable component even though the interest is a debt/equity hybrid. [Schedule 1, item 34, subsections 974-95(1) and (2)]

What is a scheme?

2.20 The term scheme sometimes has a tax avoidance connotation. However, as indicated in paragraph 2.6, it is used in the debt/equity tests in a broader sense that covers ordinary situations as well. It is used here in the sense of an arrangement, but one that also incorporates unilateral arrangements (see the definition of scheme in subsection 995-1(1) of the ITAA 1997).

2.21 In the context of the equity test, the relevant scheme will usually constitute just a single instrument - a share, for example. In more complicated cases the relevant scheme may constitute a particular instrument affected by some other arrangement - for example, a share combined with a guarantee as to payment of dividends. In the former case the share will constitute an equity interest unless it satisfies the debt test. In the latter case, the share will constitute an equity interest unless the interest of which it is a part (i.e. including the guarantee) satisfies the debt test.

2.22 It is a question of fact depending on all the relevant circumstances whether a series of transactions are part of a single scheme or constitute more than one scheme. Merely because transactions are undertaken under one agreement does not necessarily mean that they are all part of the one scheme. For example, an employment contract that provides for the payment of salary and, in addition, the issue of shares in the company to the employee would not ordinarily constitute a single scheme for the purposes of the debt/equity tests. Rather it would usually be seen as constituting 2 separate schemes: one for the payment of salary and the other for the issue of shares. Similarly, without limiting the Commissioners discretion or scope of regulations, a financing arrangement and a hedging transaction (e.g. a derivative) would also usually be seen as constituting 2 separate schemes. To enable specific circumstances to be taken into account, the Commissioner has a discretion to treat a particular scheme as constituting 2 or more separate schemes. Regulations may also be made to provide further guidance on when a scheme is treated as 2 or more separate schemes. [Schedule 1, item 34, subsections 974-150(2) and (3)]

The table in subsection 974-75(1)

2.23 The first item in the table in subsection 974-75(1) simply identifies the current class of equity interests in a company, namely the interests held by members and stockholders (i.e. shares and stock). Shareholders in a company are members for these purposes, as are guarantors of a company limited by guarantee. [Schedule 1, item 34, subsection 974-75(1), item 1 in the table]

2.24 The reference to stockholders in a company incorporates the concept of fractional interests in shares known as stock. Until 1 July 1998 Australian companies could issue stock, but are now prevented from doing so due to Corporations Law reforms. Thus the concept of stock is no longer relevant for companies incorporated under the Australian Corporations Law . However, the concept of stock as a fractional interest in shares may still be relevant for companies incorporated in other jurisdictions. Therefore that concept has been retained in the income tax law by the reference to stock in the definition of a share in subsection 995-1(1) of the ITAA 1997, and by the reference to stockholders in the table in subsection 974-75(1).

2.25 Items 2 to 4 in the table bring within the equity concept interests which, because of their legal form, cannot provide frankable returns under the current law, even though, in economic substance, they have significant equity features. Under the new law the legal form of an interest does not preclude the franking of its returns. An interest referred to in these items in the table may or may not represent a proprietary right or chose in action . [Schedule 1, item 34, subsection 974-75(3)]

2.26 Item 2 in the table treats as equity interests (subject to the debt test explained in paragraphs 2.124 to 2.209), interests that provide an effectively contingent (i.e. contingent in substance or effect, even if not in legal form) right to a return (whether fixed or variable), or an absolute right to a contingent return. In this context a return is both a return on an investment and a return of an investment. For example, dividends are returns on an equity interest, and the redemption proceeds of a share constitute the return of the investment: either may be contingent on economic performance, and both are returns for the purposes of this definition of an equity interest. [Schedule 1, item 34, subsection 974-75(1), item 2 in the table]

2.27 The relevant contingency is the economic performance of the company (or a part of the companys activities) that issued the interest, or that of a connected entity (defined in subsection 995-1(1) of the ITAA 1997 to mean an associate - defined by reference to section 318 of the ITAA 1936 - or a member of the same wholly-owned group) of the company. [Schedule 1, item 34, subsection 974-75(1), item 2 in the table]

Example 2.5: Contingent right

A company issues an interest which gives its holder the right to $100 in each year that a company within the same wholly-owned group makes a profit.

The interest satisfies item 2 in the table in subsection 974-75(1) because there is a right which is contingent on the economic performance of a connected entity of the company.

Example 2.6: Contingent return

A company issues an interest which gives its holder the right to 1% of the profits made by the companys steel-making business.

The interest satisfies item 2 in the table in subsection 974-75(1) because there is a right to a return which is contingent on the economic performance of part of the companys activities.

The scope of economic performance

2.28 Item 2 in the table requires a link between the return to the investor and the economic performance of the issuer (i.e. the company in which the interest exists - see new subsection 974-95(5)) or a connected entity of the issuer. An interest whose returns are contingent on something other than the economic performance of the issuer or a connected entity is not brought within the item. For example, an option issued by a company over shares in an unconnected entity does not constitute an equity interest in the issuer even though the return to the investor is contingent.

2.29 The economic performance on which the returns are based may be past, present or future economic performance of the company. In addition, there is no requirement that the link between economic performance and the return be a direct one. It is sufficient that the return is, in substance, contingent on economic performance of the company, even if the link is an indirect one.

Example 2.7: Contingent on economic performance

A company issues an interest to a trust that has issued income securities to its beneficiaries. The income securities provide returns that are contingent on the profits of the company. The interest issued by the company to the trust provides returns based on the returns on the income securities.

The returns on the interest issued to the trust are contingent on the economic performance of the company because they are based on the returns on the income securities, which are contingent on profits (i.e. a manifestation of the companys economic performance). This is the case whether the returns are cumulative or non-cumulative; however, if the returns are cumulative, the interest is more likely to satisfy the debt test.

2.30 The right that a creditor has to a return may be said to be contingent on the debtor company being able to meet its debts when they fall due. That by itself will not be taken as meaning that the right is contingent on the economic performance of the company. [Schedule 1, item 34, paragraph 974-85(1)(a)]

2.31 To promote certainty, regulations may prescribe circumstances in which a right or return is taken to be contingent, or not contingent on economic performance means. [Schedule 1, item 34, subsection 974-85(2)]

Disregarded kinds of economic performance - de minimis contingencies and turnover-based payments

2.32 There can be circumstances where a right to a return or an amount of return is based on the turnover of the entity obliged to make the relevant payments. An example is a lease contract where part of the rentals are based on the lessees turnover. Generally speaking, turnover-based returns will be excluded from being regarded as contingent on economic performance in the relevant sense. [Schedule 1, item 34, paragraph 974-85(1)(b)]

2.33 However, there may be types of contracts where turnover is a close proxy for an economic performance indicator other than turnover (e.g. profitability) of the payer. Regulations may be made to treat such contracts as equity interests. Regulations may also be made to clarify when a particular return is or is not contingent on economic performance. [Schedule 1, item 34, subsection 974-85(2)]

2.34 Where a right to a return or an amount of return on an interest is contingent on profitability or some other economic performance indicator (other than turnover) to a minor extent, regulations may be made to exclude such types of interests from being equity interests. [Schedule 1, item 34, subsection 974-85(2)]

Returns dependent on the exercise of a discretion

2.35 Item 3 in the table in subsection 974-75(1) covers interests that provide a return (whether on or of the investment) to the holder which is at the discretion of the issuer or a connected entity. An example of this would be an interest that provides a 10% return to the holder unless the directors of the issuing company determine otherwise. In this case the right to a return is contingent on the exercise of the issuers discretion. [Schedule 1, item 34, subsection 974-75(1), item 3 in the table]

2.36 To promote certainty, regulations may specify when a particular return is at the discretion of a company or a connected entity. These regulations may, for example, explain in what circumstances a loan between connected entities (e.g. companies in the same wholly-owned group) will be treated as an equity interest because, having regard to all the surrounding circumstances, repayment is effectively at the discretion of the so-called lender. [Schedule 1, item 34, section 974-90]

Converting or convertible interests

2.37 Item 4 in the table in subsection 974-75(1) identifies interests whose equity character stems from the fact that their holder may become an equity holder in the future. These interests are convertible if the holder has a choice of whether or not to convert the interest, or converting if the conversion is automatic. Examples of such interests are convertible notes (i.e. interests which give their holder an option to convert - in a loose sense of that term - the interest into a share in the issuer) and rights issued by a company to acquire shares in the company. [Schedule 1, item 34, subsection 974-75(1), item 4 in the table]

2.38 Of course, as with the other items in the table, if the relevant interest satisfies the debt test it will not be an equity interest in the company. Therefore, not all convertible note holders will be equity holders in the company - only those whose notes are insufficiently debt-like to fall within the definition of a debt interest explained in paragraphs 2.148 to 2.157. [Schedule 1, item 34, paragraph 974-70(1)(b)]

2.39 An interest is a converting or convertible interest if:

•

the interest, or a component part of the interest, may (or must) be converted into an equity interest in the company or a connected entity (the reference to a component part addresses interests comprising a number or rights or interests, only one of which converts into an equity interest);

•

the interest, or a component part of the interest, may (or must) be redeemed, repaid or satisfied by the:

-

allotment or transfer of an equity interest in the company or a connected entity (whether to the holder of the interest or to some other person);

-

acquisition of an equity interest in the company or a connected entity (whether by the holder of the interest or by some other person); or

-

application in or towards paying-up (in whole or part) the balance unpaid on an equity interest issued or to be issued by the company or a connected entity (whether to the holder or to some other person); or

•

the holder of the interest has, or is to have, any right or option to have allotted or transferred to a person an equity interest (or a right or option to acquire an equity interest) in the company or a connected entity, or otherwise to acquire such an interest.

[Schedule 1, item 34, section 974-165]

2.40 That these events are conversion events does not carry any implication as to whether the events are disposals or not for income tax and CGT purposes.

Example 2.8: Converting or convertible interests

A company issues a stapled instrument comprising an unpaid preference share and a perpetual note whose terms provide that, if the face value of the note is redeemed, a call is made on the unpaid amount of the preference share (i.e. there is an effective, but not an actual, conversion of the note into a preference share).

A variation on this type of instrument is where the redemption of the note triggers an obligation of the holder to acquire an equity interest in the issuer from a connected entity of the issuer.

In both these cases the interest is a converting or convertible interest that falls within item 4 in the table in subsection 974-75(1). Whether or not they constitute equity interests depends on whether they satisfy the debt test.

Interests that fund returns on equity interests

2.41 Sometimes it is possible for an effective equity interest in a company to arise even though the holder of the interest has no direct interest in the company. Instead there may be a series of related arrangements entered into by the company and connected entities culminating in the payment of a return to an investor in respect of an interest which provides the investor with an effective interest in the company.

2.42 A common scenario where this can arise is the issue of an equity interest through a SPV controlled by a holding company. Diagram 2.1 illustrates an example of this structure.

Diagram 2.1

2.43 In Diagram 2.1 there is a series of related arrangements under which the ultimate investors have obtained an effective, but not an actual, equity interest in the holding company. The investors hold units in a the SPV which provide returns contingent on the profits of the holding company and which may convert into ordinary shares of that company. The subscription price has been on-lent, at interest, by the SPV to the holding company through its subsidiaries. The holding company has funded the contingent returns paid by the SPV by way of the payment of interest through its subsidiaries. Assuming the SPV is a trust, the investors do not have a direct equity interest in any company. The structure relies not only on the interest on loans made by the subsidiaries being deductible, but also the returns paid by the SPV being deductible, perhaps under the terms of a foreign tax law, notwithstanding that the latter are profit-contingent. This is designed to ensure that the holding companys corporate group has received a net tax deduction for the funding of effective dividends to effective shareholders in the holding company.

2.44 The appropriate tax outcome for situations like this one where related arrangements comprise an effective equity interest is to treat the related arrangements which effectively fund the payment of the returns on the effective equity interest (i.e. the returns to the investors in the SPV in Diagram 2.1) as equity interests. Thus the loans by the subsidiary companies in Diagram 2.1 would be equity interests rather than debt interests because they are interests issued by related companies which are used to fund the payment on the deemed equity interest. [Schedule 1, item 34, section 974-80]

2.45 The starting point in determining whether an equity interest arises in cases like these is to look at the holder(s) of all the related arrangements. The combined effect of related arrangements will result in the holder of an interest (in any entity) having an equity interest in a company if:

•

the interest (even though it is issued by another entity) will or may convert into an equity interest in the company, or provides returns which are either contingent on the economic performance of the company or a connected entity, or at their discretion; or

•

returns on the interest are effectively from the company because, although there is no direct payment to the holder by the company, the company provides a return to another entity which effectively on-pays that amount (directly, or through interposed related companies) to the entity that provides the return to the holder.

2.46 The consequence of this type of arrangement is that all the interests through which the ultimate returns are funded are taken to be equity interests (in the entity in which the interest is directly held). In these cases it does not matter that the payment(s) that fund the ultimate return to the holder of the interest that represents an effective equity interest in a company may not themselves be contingent on the economic performance of the paying company or be at its discretion. Thus, in Diagram 2.1, the on-payments actually constitute interest on a loan between the connected entities and are not contingent on economic performance at all. However, when combined with the interest held by the investors in the SPV, they ensure that the return to the investors are effectively from the holding company (on whose economic performance the returns are based), albeit indirectly through a number of entities and by way of interest payments on loans.

2.47 It is important to note that, in these cases, the only entity taken to have an equity interest in the company is the entity which holds a direct interest in the company and which funds the payment to the investor whose return represents an effective equity interest in the company. That investor, and any interposed entities, is not taken to be an equity holder in the company itself - just an equity holder in the entity in which the investor has a direct interest. If the interest is held in a connected entity that is not itself a company (e.g. a trust) then it will not be an equity interest (because only companies, or entities taxed as companies, can issue equity interests). However, because the payments to fund the ultimate return must (by definition) flow through that non-corporate entity, the entity itself will have an equity interest in the company or a related company.

2.48 Section 974-80 applies to treat an interest in a company as an equity interest only if that interest is not already an equity interest. Therefore if in Diagram 2.1 the loans between the connected entities were back-to-back equity interests mirroring the interest issued by the SPV, section 974-80 would have no effect. [Schedule 1, item 34, paragraph 974-80(1)(c)]

2.49 As a result, the debt test (see paragraphs 2.124 to 2.209).) does not apply individually to each of the interests identified in section 974-80 which fund the return to the ultimate recipient. Instead, the test applies in relation to the interest held by the ultimate recipient - if that satisfies the debt test then the funding interests will not be equity interests. For example, if the interest in the SPV in Diagram 2.1 constituted a debt interest in the SPV because the SPV or a connected entity guaranteed repayment of the subscription price within 10 years, none of the loans between the connected entities would be an equity interest. [Schedule 1, item 34, subsection 974-80(2)]

Example 2.9: Application of section 974-80 to a stapled security

An Australian resident bank issues a fully-paid preference share to a trust that is controlled by its subsidiary. The subsidiary issues to the trust a deeply-subordinated perpetual note that pays a non-cumulative coupon whose payment is contingent on distributable profits of the bank. The trust then issues to investors a stapled security for $100 comprising a beneficial interest in the note and the preference share.

The holders of the security receive a non-cumulative coupon whose payment is contingent on distributable profits of the bank. While the note pays the coupon, the preference share pays no dividends.

The funds raised by the issue of the stapled securities are lent by the trust to the subsidiary and then on-lent by the subsidiary to the bank at a fixed market rate of interest under a term security.

The bank has issued an interest (the term security) to its subsidiary (a connected entity) which carries a right to a fixed return. The interest would not (but for section 974-80) be an equity interest in the bank. However, there is a scheme under which the return to the connected entity is to fund (indirectly through the trust) a return to the ultimate recipient of the return, who is the holder of the stapled security. The amount of the return to the holder of the stapled security is effectively contingent on the economic performance of the bank since it is a return on the beneficial interest in the note, whose returns are contingent on the economic performance of the bank.

Under subsection 974-80(2) the term security (representing the loan to the bank of the funds raised on the issue of the stapled security) constitutes an equity interest in the bank. As an equity interest, the bank is liable to frank the term security coupons.

The subsidiary company has also issued an equity interest (the perpetual note) which is an equity interest under item 2 in the table in subsection 974-75(1).

Example 2.10: Application of section 974-80 to offshore trust units exchangeable into preference shares

An Australian resident bank issues trust preferred securities through a trust in Foreign Country 1 to investors in that Foreign Country. The securities are perpetual and exchangeable into the banks preference shares. They provide non-cumulative returns contingent on profits of the bank.

The proceeds ofthe Foreign Country 1 issue are used by the trust to purchase redeemable debt securities issued by a special purpose subsidiary of the bank that is resident in Foreign Country 2. These securities pay an arms length, fixed rate of interest to the Foreign Country 1 trust, which is used to fund the returns to the investors in the trust. The proceeds from the Foreign Country 2 issue are on-lent to the bank by the subsidiary in Foreign Country 2 on terms similar to the redeemable debt securities. Should a contingency occur such that the trust is not required to pay a return to its investors, the funds are made available to the bank.

Section 974-80 applies to this trust preferred issuance as follows. The Foreign Country 2 subsidiary has an interest in the bank (a connected entity) that carries a right to a fixed return from the bank. That interest would not otherwise be an equity interest in the bank (because it would otherwise be a debt interest). However, there is a scheme or a series of schemes under which the return to the Foreign Country 2 subsidiary funds the return to the Foreign Country 1 investors, albeit indirectly through the trust.

Thus, the return to the Foreign Country 1 investors, which is ultimately funded by the interest payments by the bank to the Foreign Country 2 subsidiary, is effectively contingent upon the economic performance of the bank, in addition to them being convertible into equity interests of the bank (the preference shares). Therefore the interest held by the Foreign Country 2 subsidiary in the bank is an equity interest in the bank, returns on which are not deductible but may be frankable and, if not franked, subject to dividend withholding tax.

Integration of related schemes

2.50 Some interests in a company are made up of 2 or more related instruments. To provide a correct reflex of the economic substance of related instruments of this kind it is necessary to integrate them and treat them as a single interest for the purposes of the equity interest definition (and, in turn, for determining whether the terms of the interest satisfy the debt test).

2.51 Therefore, an integration test is required for determining whether an interest is an equity interest in a company. The test adopted by this bill draws on subsection 82L(2) of the ITAA 1936 (applicable to convertible notes). Under this test, 2 or more related schemes (whether or not they come into existence at the same time) to which a company is a party give rise to an equity interest in the company if they would have done so had they constituted a single scheme. [Schedule 1, item 34, subsection 974-70(2)]

2.52 This integration test applies where 2 or more schemes which, by reason of the relationship that they bear to each other or the connection that they have to one another, can be said to be related and operate together to have the effect or operation of an equity interest in a company. For the schemes to be integrated, the company must be a party to them, in the sense that it must enter into, cause another entity to enter into, participate in, or cause another entity to participate in, the schemes. This ensures that a company will not be taken to have issued an equity interest if it has not been involved in some way in its creation. Also, the combined effect of the schemes to produce an equity interest must be intended by the company rather than being produced by mere chance. [Schedule 1, item 34, subsection 974-70(2)]

2.53 Interests that are referred to as being stapled together (in the sense that they are not detachable from each other) would constitute related schemes for these purposes. In this context stapled instruments has its ordinary commercial meaning. [Schedule 1, item 34, paragraph 974-155(2)(a)]

2.54 In addition, the following examples of interests would be related even if they are detachable:

•

interests that are commercially connected in the sense that it is unlikely that one would be entered into without the other;

•

interests that are dependent for their effect or operation on the effect or operation of another interest; and

•

interests that complement or supplement the effect or operation of each other.

[Schedule 1, item 34, subsection 974-155(2)]

2.55 Schemes can be integrated for these purposes even if one or more of them constitutes an equity interest in its own right (e.g. a stapled security comprising an interest-bearing note and a preference share). In this regard the decision of Network Finance Pty Ltd v FCT (1976)
6 ATR 589 is overcome. (In the Network Finance case it was held that if an interest in itself is a convertible note, it cannot also be related to another interest to cause it and that other interest to be treated as a convertible note). [Schedule 1, item 34, subsection 974-70(2)]

2.56 However, if all the related schemes are equity interests themselves, they will not be integrated to form a separate, combined equity interest. [Schedule 1, item 34, subsection 974-70(3)]

2.57 If related schemes are combined to form a single integrated equity interest, returns in respect of the individual schemes are taken to be returns in respect of the integrated equity interest and not in relation to any other interest. For example, a stapled interest-bearing note and preference share that do not satisfy the debt test would be taken to be a single equity interest, and both the interest payments on the note and dividends on the share would be taken to be payments in respect of that interest and not payments in respect of the note or the share as separate instruments. [Schedule 1, item 34, section 974-105]

2.58 In addition, the debt test applies to the single interest arising from the integrated schemes rather than each component part. Therefore it is possible to have an interest arising from integrated schemes that include interests listed in the table in subsection 974-75(1) being treated as a debt interest. An example of such an interest is a preference share stapled to a note which constitute separate schemes and together satisfy the debt test. [Schedule 1, item 34, subsections 974-70(1) and (2)]

Commissioners discretion not to integrate

2.59 To ensure the proposed debt/equity rules are not undermined by the issue of discrete instruments with a combined effect equivalent to an equity (or debt interest), it is necessary to have a broad integration rule of the kind explained in paragraphs 2.50 to 2.58.

2.60 However, it is possible that such a broad rule could operate inappropriately, having regard to the objects of the debt/equity test in general and the integration rule in particular. For example, schemes that are related schemes within the definition of that term which could technically be combined to produce a particular effect may, in economic substance, have a different effect. In these cases the Commissioner may determine that it would be inappropriate to integrate certain schemes. In this regard the Commissioner will be guided by the purpose of the scheme, as well as their effect. [Schedule 1, item 34, subsection 974-70(4)]

Non-arms length arrangements

2.61 The debt test is applied to all interests that are identified in the table in subsection 974-75(1) - those that satisfy the test cannot be equity interests. However, interests that arise from a non-arms length dealing cannot satisfy the debt test if they fall within one of the items in the table in subsection 974-75(1) and it is reasonable to suppose that they would have been equity interests if the relevant scheme had been conducted at arms length. Therefore, if such arrangements are covered by an item in the table they will be equity interests and distributions on them may be frankable but will not be deductible. [Schedule 1, item 34, subsection 974-25(1)]

2.62 The reason for excluding non-arms length arrangements of this kind is because otherwise they could nominally satisfy the debt test without representing genuine debt. Some examples include non-arms length loans to a company within the same company group as the so-called lender, and artificial arrangements under which family members obtain an interest in a family company by paying an insignificant sum to the company, which guarantees repayment of the insignificant sum within 10 years. It would be inappropriate to allow such arrangements to be treated as debt.

2.63 Non-arms length arrangements arise if the parties to the relevant scheme are not dealing with each other at arms length. The term dealing at arms length has an established meaning in Australia and internationally, for example in double tax agreements. Parties are dealing at arms length where they have acted severally and independently in forming their bargain (see Granby v FCT
95 ATC 4240 at 4243). Lee J in that case said:

". . . The expression dealing with each other at arms length involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction. What is asked is whether the parties behaved in the manner in which parties at arms length would be expected to behave in conducting their affairs." ( Granby v FCT
95 ATC 4240 at 4243)

2.64 Therefore a key aspect to the test is whether the parties to a transaction behaved in the manner in which parties at arms length would be expected to behave in conducting their affairs.

2.65 The courts have held that the actual relationship of the parties is not determinative of the question of whether parties are dealing at arms length. Hill J in AW Furse No 5 Will Trust v FCT
91 ATC 4007 at 4014-1015 stated that the fact that the parties are themselves not at arms length does not mean that they may not, in respect of a particular dealing, deal with each other at arms length. Determining whether an entity did not deal at arms length in connection with an arrangement is a question of fact having regard to all of the circumstances.

2.66 The definition of arms length in subsection 995-1(1) of the ITAA 1997 provides that in determining whether parties deal at arms length it is necessary to consider any connection between the parties and any other relevant circumstances.

Non-share equity interests

2.67 Subject to the debt test, shares are equity interests (as they are under the current law). However, not all equity interests in a company are shares.

2.68 As a general rule, equity interests are treated alike for the purposes of determining the taxation treatment of returns (including imputation and withholding tax), whether or not they are shares in legal form. Therefore, the concepts of share and shareholder in relevant provisions of the income tax law have been expanded to encompass all types of equity interests and equity holders (see paragraphs 2.17 to 2.19). Where necessary, specific modifications have been made to particular provisions (e.g. to subsection 44(1) and sections 45A, 45B, 45C and 159GZZZP of the ITAA 1936). [Schedule 1, items 57 to 60, 88 and 89]

2.69 However, it is necessary to distinguish between equity interests that are in the form of a share and those that are not for the purposes of determining what is a distribution and what is a capital return on an equity interest. To enable this, this bill creates the concept of a non-share equity interest, that is to say, an equity interest that is not solely in the form of a share (which is defined in subsection 995-1(1) of the ITAA 1997 to include stock). [Schedule 2, item 18, definition of non-share equity interest in subsection 995-1(1)]

2.70 For an equity interest to be a non-share equity interest it is necessary for the whole interest, or a component part thereof, to be in a form other than a share. Therefore, if an equity interest in a company is made up of related interests and at least one of those interests is not a share (for instance, a preference share which is stapled to a note) the interest is a non-share equity interest. [Schedule 2, item 18, definition of non-share equity interest in subsection 995-1(1)]

2.71 Capital raised by a company from the issue of non-share equity interests is credited to a non-share capital account (see Chapter 4). [Schedule 1, item 33, section 164-10]

2.72 An example of how equivalent tax treatment applies for non-share equity interests and equity interests in the form of shares (that are not non-equity shares) is provided by the amendments to the imputation provisions in Part IIIAA of the ITAA 1936. Those provisions apply in relation to non-share equity interests in the same way as they apply to shares [Schedule 1, item 93, section 160AOA] . Thus references to shares in the imputation provisions can be read as including non-share equity interests.

2.73 For example, the definition of excluded shares in existing subsection 160APHBC(3) of the ITAA 1936 (which is used for the purposes of determining whether a company is effectively wholly-owned by a non-resident or tax-exempt entity) will, because of the amendments made by this bill, now apply to non-share equity interests as well. Given that non-share equity interests are unlikely to entail the risks and opportunities ordinarily attached to ordinary shares, the effect of the definition in that subsection would be to treat most non-share equity interests as excluded shares.

2.74 Another example of the effect of applying the imputation system to non-share equity interests in the same way as equity interests in the form of shares (that are not non-equity shares) is provided by the definition of preference shares in section 160APHD of the ITAA 1936 (which is relevant for the holding period rule). Applying that definition to non-share equity interests will result in many of them being preference shares for the purposes of the holding period rule because they will often be less risky than ordinary shares.

What is a frankable distribution on a non-share equity interest?

2.75 In essence, a payment to a non-share equity interest holder that corresponds to a dividend paid to a shareholder is treated in the same way as a dividend. This is effected by the definitions of non-share distribution and non-share dividend, which are based on the definition of a dividend in the ITAA 1936. [Schedule 1, item 34, sections 974-115 and 974-120]

2.76 The starting point is the definition of a non-share distribution . This is the distribution of money or property, or the crediting thereof, by the company to a non-share equity holder. In this context distribution has a very broad meaning that would encompass, for example, the repayment of a profit-participating loan. [Schedule 1, item 34, section 974-115]

2.77 A non-share distribution will usually constitute a non-share dividend (which corresponds to a dividend on a share). However, this is qualified by a capital distribution exception corresponding to the exception (subject to certain anti-avoidance rules) for distributions to a shareholder which are debited to the share capital account. In the case of the holder of a non-share equity interest, the exception relates to distributions debited to the non-share capital account of the company, or, where company law permits it, to the (untainted) share capital account. (As a general rule, a share capital account is tainted if an amount other than share capital is credited to it.) [Schedule 1, item 34, subsections 974-120(1) and (2)]

2.78 These capital distributions are called non-share capital returns and are taxed as returns of capital rather than as dividends. [Schedule 1, item 34, section 974-125]

Anti-avoidance rules

2.79 To prevent the substitution of concessionally-taxed capital gains for taxable dividends, a company may only debit a distribution to its non-share capital account to the extent that the distribution is made as part of a process that results directly in a non-share equity interest ceasing to exist (e.g. by its redemption or cancellation), or to the extent that the distribution is in connection with a reduction in its market value (e.g. by partly repaying a profit-participating loan) [Schedule 1, item 33, subsection 164-20(1)] . Also, the capital distribution made in relation to a particular non-share equity interest cannot exceed the capital contributed in relation to that particular interest [Schedule 1, item 33, subsection 164-20(2)] .

2.80 Other anti-avoidance provisions relevant to ordinary shares (e.g. the capital streaming and dividend substitution rules contained in sections 45A and 45B of the ITAA 1936) are also applicable in relation to non-share equity interests because the broad definition of equity and its related concepts are extended to them [Schedule 1, item 56, section 43B of the ITAA 1936] . Where necessary, minor modifications have been made to those provisions to ensure they can apply in relation to non-share equity interests [Schedule 1, items 58 to 60] .

General tax treatment of non-share dividends

2.81 If a non-share distribution is a non-share dividend it is generally included in the assessable income of the non-share equity holder. Unlike dividends paid on shares, non-share dividends might be paid even if the paying company has no profits. Therefore, the inclusion of such dividends in assessable income does not depend on them being sourced from profits (as it does for shares). This is reflected in the amended section 44, which also include a clarificatory note providing a non-exhaustive list of some of the provisions of the income tax law to which the section is subject. [Schedule 1, item 57, subsection 44(1) of the ITAA 1936]

2.82 If the recipients of non-share dividends are non-residents, the source of the dividends is relevant. In these cases, the recipient is assessable in respect of the non-share dividend only if it is derived from sources in Australia. For this purpose, it is relevant to consider that the underlying purpose of the debt/equity rules is, generally, to treat non-share dividends in a similar way to normal dividends. Although questions of source are governed by the facts of each particular case, the source rules applicable to dividends are the more appropriate ones to apply. In a typical case, the place of residence of the entity paying the non-share dividends will be the source from which the dividends are derived.

2.83 As is the case with dividends on shares which are equity interests, non-share dividends are not deductible. Instead, they are generally frankable in accordance with the rules governing frankability of dividends in the imputation system. Similarly, returns accrued but not paid in respect of a non-share equity interest are not deductible. [Schedule 1, item 4, section 26-26]

Franking of non-share dividends generally

2.84 Non-share dividends are generally frankable in the same circumstances that dividends on shares (share dividends) are frankable. However, some special rules apply.

Special franking rule for non-share dividends: non-share dividends are not frankable unless profits are available

2.85 Under the current law dividends on shares have to be paid out of realised profits to be frankable. Thus dividends debited to share capital or asset revaluation reserves are not frankable (see sections 46G to 46M of the ITAA 1936). Although non-share dividends debited to those sources will also be unfrankable, there is no general requirement that they be debited to realised profits to be frankable. This could give rise to opportunities to stream franking credits in circumstances where there is no such opportunity under the current law because the relevant company has no profits. Of course the issue of a non-share equity interest under a scheme with a purpose to provide a franking benefit would be subject to the rule in section 177EA of the ITAA 1936 preventing franking credit trading. However, that provision is not self-executing and requires a Commissioners determination to operate.

2.86 Therefore, to prevent the use of non-share dividends to stream franking credits, the ability to frank non-share dividends is capped by reference to available frankable profits. These are profits that are available to pay frankable dividends (therefore they exclude unrealised profits). If a company does not have any such profits then it will be unable to frank non-share dividends. [Schedule 1, item 98, subsection 160APAAAB(2) of the ITAA 1936]

2.87 The concept of available frankable profits takes into account the available profits of the company at the time it pays a non-share dividend, having regard to future claims on those profits by dividends on shares (share dividends) which have yet to be paid, and also past claims on those profits by non-share dividends that have been franked on the basis of profits available at the time of their payment (though were not actually debited to those profits, thereby allowing them to be used to fund frankable share dividends). To avoid the complexities and compliance costs that could arise from the establishment of a notional account to record available frankable profits that have already been used to support the franking of a non-share dividend, a simple calculation method is used which focuses only on non-share dividends paid in the preceding 2 franking years (or under the same scheme). [Schedule 1, item 98, subsection 160APAAAB(10) of the ITAA 1936]

Example 2.11: Available frankable profits

On 1 January 2002 a company has $1 million realised profits. It pays a franked non-share dividend of $600,000 on that day, but the dividend is not debited to those profits. On 1 February 2002 the company announces another non-share dividend to be paid on that day (but not debited to the profits), and a $400,000 dividend to its ordinary shareholders to be paid in the following month. No profits were derived during January.

The company has no available frankable profits on 1 February. This is because $600,000 of the $1 million has already been accounted for in allowing the franking of the first non-share dividend, and the remaining $400,000 has to be set aside for the dividend to the companys ordinary shareholders.

Because there are no available frankable profits at the time it pays the second non-share dividend, the company is unable to frank it (subject to its ability to anticipate profits - see paragraph 2.89).

2.88 If a company has no available frankable profits when it pays a non-share dividend then the whole of that dividend is unfrankable. [Schedule 1, item 98, subsection 160APAAAB(2)]

2.89 If the available frankable profits of a company when it pays a non-share dividend is less than the amount of that dividend, then, in effect, the non-share dividend is partly frankable. The mechanism for achieving this is the same as that employed in section 46M of the ITAA 1936 in relation to dividends debited to share capital accounts or asset revaluation reserves. Thus the non-share dividend is notionally split into 2 non-share dividends: one frankable; the other not. To ensure this notional splitting of the dividend does not result in untoward consequences in relation to the required franking rules, the non-share dividend that is taken to be the unfrankable dividend is not a dividend to which those rules apply (nor is a dividend which is wholly unfrankable because there are no available frankable profits). [Schedule 1, item 98, subsections 160APAAAB(3) to (5)]

2.90 In certain situations the calculation of available frankable profits could disadvantage a company. These are where the company has committed itself to paying dividends on shares in the future and expects to derive available profits between the time it committed itself to their payment and the time of payment, and, but for the committed dividends, the company would have been able to frank a non-share dividend. In these cases the company can estimate future profits to the extent it expects them to arise, and provided the estimated profits do not permit the franking of the non-share dividend to an extent greater than would be the case if the committed share dividends did not exist. [Schedule 1, item 98, subsections 160APAAAB(6), (6A) and (7)]

2.91 To prevent a company over-estimating future profits, a franking debit arises if it over-estimates future profits. The debit arises at the earlier of the time the committed share dividends are paid and the end of the franking year following payment of the non-share dividend. [Schedule 1, item 98, subsection 160APAAAB(8)]

Special franking rule for non-share dividends: certain non-share dividends of ADIs are not frankable

2.92 New section 160APAAAA removes a competitive disadvantage that Australian ADIs would otherwise suffer from the introduction of the new debt/equity rules. [Schedule 1, item 98, section 160APAAAA]

2.93 Australian ADIs are subject to APRA regulations under which there are advantages for the ADI to raise Tier 1 capital through branch structures rather than through foreign subsidiaries. At present, foreign branches and subsidiaries of Australian ADIs compete, broadly, on an equal footing with foreign independent entities which raise capital overseas by the issue of hybrid instruments. These instruments form part of the Tier 1 capital of the Australian ADI under APRA prudential standards. The new debt/equity rules will result in some hybrid instruments which are currently treated as debt interests for income tax purposes being recharacterised as non-share equity interests (eligible hybrids). A consequence is that an Australian ADI (i.e. the entity legally liable in the head office/branch structure) would need to frank the returns on these instruments (i.e. non-share dividends). This is an inherent additional cost of raising capital overseas which would not be incurred if the Australian ADI issued eligible hybrids through a foreign subsidiary and is a cost which may not be incurred by a foreign independent entity raising capital in the same way.

2.94 This measure prevents the disadvantage from arising by treating the returns on the eligible hybrids as unfrankable dividends of the ADI. Aligning the taxation treatment of foreign branches with that of foreign subsidiaries of the ADI and foreign independent entities in relation to the issue of eligible hybrids will assist Australian ADIs to grow their businesses conducted through foreign branches. Conditions for the application of the concession are explained in paragraphs 2.95 to 2.114.

Which non-share dividends qualify as unfrankable dividends under the ADI concession?

2.95 Even though eligible hybrids may be issued out of a foreign branch, the Australian ADI (or head office) is the entity legally liable for payment of the returns and subject to APRA regulations. Moreover, eligible hybrids issued by a foreign branch are assessed as to whether they can form part of the Tier 1 capital of the ADI. Accordingly, the concession applies in respect of non-share dividends paid by an ADI in respect of non-share equity interests issued by a foreign branch but which form part of the Tier 1 capital of the ADI. [Schedule 1, item 98, paragraph 160APAAAA(1)(b)]

Which entities qualify for the ADI concession?

2.96 Only ADIs which are Australian residents will qualify for the concession. Entities qualify as ADIs under the Banking Act 1959 and are subject to APRA regulations. [Schedule 1, item 98, paragraph 160APAAAA(1)(a)]

2.97 The concession is further confined to Australian ADIs which have branches in broad-exemption listed countries (BELCs). A BELC has the meaning given in Part X of the ITAA 1936 which deals with controlled foreign companies. BELCs include the major international capital centres through which Australian ADIs raise capital and represent countries with taxation systems comparable to those of Australia, that is, United States of America, United Kingdom, Canada, New Zealand, Japan, France and Germany. [Schedule 1, item 98, paragraph 160APAAAA(1)(c)]

2.98 A branch is a permanent establishment as defined in section 6 of the ITAA 1936. Broadly, it is a place at or through which an Australian ADI carries on business in a foreign country.

What hybrids are eligible for the ADI concession?

2.99 Eligible hybrids have 2 characteristics. First, they must be non-share equity interests under the new debt/equity rules. These are explained in paragraphs 2.67 to 2.74 and include innovative hybrid instruments which, in the absence of the debt/equity rules, would be debt instruments. [Schedule 1, item 98, paragraph 160APAAAA(1)(b)]

2.100 The other characteristic of an eligible hybrid is that the equity interests must form part of the Tier 1 capital of the Australian ADI under the APRA prudential standards. [Schedule 1, item 98, paragraph 160APAAAA(1)(b)]

Rules relating to the raising and application of funds raised in relation to the ADI concession

2.101 Paragraph 160APAAAA(1)(d) contains a test relating to the raising and application of funds raised from the issue of eligible hybrids (the funding test) [Schedule 1, item 98, paragraph 160APAAAA(1)(d)] . This test is linked, but is not exclusively related, toitem 101 of Schedule 1which deals with anti-streaming rules relating to this concession. Those rules are explained in paragraphs 2.117 to 2.119.

2.102 The funding test is primarily an integrity measure to prevent avoidance of franking debits if the eligible hybrids were issued in Australia. This would occur, for example, if the Australian ADI needs to raise capital for its Australian operations and thereby incur franking debits on the returns but instead raises the capital through its foreign branch and immediately, or sometime later, the funds are transferred to the Australian head office.

2.103 Consistent with the underlying intent of the measure, the test requires that the funds from the issue of eligible hybrids be raised and applied for permitted purposes . Essentially, the test ensures that the funds are raised and used solely for the business of the foreign branch and not for the Australian operations of the group. Broadly, an indicator that the test is satisfied is if the amount of capital attributed to the foreign branch is equal to or greater than the value of eligible hybrids on issue by that branch. [Schedule 1, item 98, paragraph 160APAAAA(1)(d)]

2.104 Permitted purposes are contained in subsection 160APAAAA(2) and explained in paragraphs 2.105 to 2.113. [Schedule 1, item 98, subsection 160APAAAA(2)]

Inter-relationship of the business of foreign branch and the funding test in the ADI concession

2.105 What constitutes the business of the foreign branch is to be interpreted in the context of the normal operations of a banking business. Principal activities include the raising of funds; the making of loans; the acquisition of debt securities and the redemption of debt (or equity interests) on maturity or earlier in order to reduce the cost of capital. [Schedule 1, item 98, paragraph 160APAAAA(2)(a)]

2.106 The conduct of a banking business by a foreign branch includes transactions with subsidiaries or other branches of the Australian ADI or of connected entities as well as with third parties each of which may be located in Australia or overseas. If the funding test were to apply without restriction, funds raised by the issue of eligible hybrids could be lent or transferred to fund the Australian operations of the group. These loans or transfers could be made for the purpose of relieving the Australian entities from franking debit obligations if they had issued the eligible hybrids. To prevent this outcome, the funding test prescribes that the test is not satisfied if the foreign branch which raises funds by the issue of eligible hybrids transfers those funds, other than as a return of amounts (see paragraphs 2.110 to 2.113), to:

•

its Australian head office [Schedule 1, item 98, subparagraph 160APAAAA(2)(a)(i)] ;

•

any connected entity of the Australian ADI that is a resident of Australia [Schedule 1, item 98, subparagraph 160APAAAA(2)(a)(ii)] ; and

•

any Australian branch of the ADI or of a connected entity of the ADI [Schedule 1, item 98, subparagraph 160APAAAA(2)(a)(iii)] .

2.107 A connected entity is one within the meaning of that term in subsection 995-1(1) of the ITAA 1997 and, in the context of this measure, includes:

•

an Australian parent company of an Australian subsidiary with the foreign branch;

•

an Australian subsidiary of the ADI or of another subsidiary of the ADI; or

•

an Australian subsidiary of one or more of the above entities.

2.108 The exclusion applies equally if the funds are moved direct to the entities mentioned or whether they are moved through intermediaries to the Australian destinations. [Schedule 1, item 98, paragraph 160APAAAA(2)(a)]

2.109 The movement of funds may occur under different circumstances. Funds are usually moved as part of normal business operations but may equally be moved not in the ordinary course of business. For example, consider the closure of a foreign branch which is found to be unprofitable several years after the issue of eligible hybrids which are still current. The transfer of surplus funds to the Australian head office of an amount equal to or greater than the value of eligible hybrids on issue has the effect of providing capital which, if raised by the Australian ADI, would give rise to franking debits on the returns paid. Whether a transaction of this kind fails the funding test turns on a finding on the facts of the case that the purpose of the raising and application of funds from the issue of eligible hybrids was not solely for a permitted purpose.

Factors determining the purpose of the raising and application of funds

2.110 As a general rule, the purpose for which funds are raised and applied becomes evident from an examination of the facts of the particular case.

2.111 The purpose for which funds are raised is normally stated in the relevant prospectus. This may have been cleared by a regulatory authority. The stated purpose for the raising of funds is, accordingly, relevant in determining whether the funding test is satisfied. However, their probative value depends on the facts of the case. For instance, a clear statement of purpose for the raising and the application of funds (e.g. to finance a named project as part of the business of the branch) and a separate announcement of a commitment to the project requiring the capital to be raised carries greater weight than a statement which is unclear. For example, a general statement of purpose (e.g. to fund the business of the branch) and evidence that funds raised were immediately transferred to the ADI in Australia to be part of its working capital suggest that the raising and application of funds were for a purpose other than for use in the business of the foreign branch.

Application of funds towards the payment of debts incurred by the foreign branch

2.112 The scope of the exclusion in paragraph 160APAAAA(2)(a) is very broad and, without restriction, would deny the concession where there is any movement of funds to the prescribed entities (see paragraph 2.106) [Schedule 1, item 98, paragraph 160APAAAA(2)(a)] . This could impose an unfair restriction on the operations of the foreign branch in relation to the redemption of debts if they were treated differently from those of foreign subsidiaries of the Australian ADI. For instance, a subsidiary could redeem its debts to lower costs of capital but redemptions of debt of the foreign branch with, say, its Australian head office would fail the funding test and result in the Australian ADI incurring franking debits on returns of the eligible hybrids. This result would be inconsistent with the objective of the measure.

2.113 Accordingly, there is a carve-out from the exclusion for:

•

a redemption by the foreign branch of a debt interest or a non-share equity interest held by a connected entity of the ADI that is a resident, if the debt interest or the non-share equity interest was issued before the relevant interest was issued by the foreign branch [Schedule 1, item 98, paragraph 160APAAAA(2)(b)] ; and

•

a return of what may be economically called loans or contributions of the Australian head office, or an Australian permanent establishment of the ADI or of a connected entity, to the working capital of the foreign branch, if the funds were contributed before the relevant interest was issued by the foreign branch [Schedule 1, item 98, paragraph 160APAAAA(2)(c)] .

Repatriation of profits

2.114 The funding test is, in substance, a matter relating to the capital of the foreign branch and its use. This is distinguishable from the application of the gains made from the exploitation of that capital. Accordingly, a repatriation of profits from the foreign branch to the Australian head office is not within the scope of the funding test. However, a purported repatriation of profits, which cannot be substantiated by reference to the current or accumulated profits of the branch, may constitute, in the context of a head office and branch structure, a transfer of capital. A transaction of this nature is relevant to a determination of whether funds have been applied solely for permitted purposes.

Certain unfrankable dividends are excluded from dividend withholding tax

2.115 Subject to certain exceptions, section 128B of the ITAA 1936, imposes a final withholding tax on unfranked dividends paid by resident companies to non-resident shareholders. Other amendments being made under the debt/equity rules will make non-share dividends subject to dividend withholding tax to the extent that the dividends are unfranked.

2.116 Non-share dividends paid to non-residents by an ADI that is a resident of Australia in respect of non-share equity interests issued by a foreign branch are, subject to conditions, to be unfrankable [Schedule 1, item 98, section 160APAAAA] . These dividends could, accordingly, be subject to dividend withholding tax. However, a withholding tax on these dividends would increase the costs of borrowing for the ADI and be contrary to the objectives of new section 160APAAAA. This outcome is avoided by making non-share dividends which are unfrankable by virtue of new section 160APAAAA to be excluded from the obligation to deduct dividend withholding tax [Schedule 1, item 86, paragraph 128B(3)(aaa)] .

Preventing the ADI concession being used to stream franking credits

2.117 There is a risk to the revenue that this ADI concession could be used by an eligible ADI to stream franking credits to certain equity holders. The most obvious type of streaming that could occur would be by issuing non-share equity interests through the ADIs branch to non-residents, while issuing similar equity interests to residents. Because the non-share equity interests issued through the branch would be unfrankable under the ADI concession, the effect of such conduct would be to stream franking credits from non-residents (who are unable to fully benefit from franking) to residents (who benefit most from franking). While this type of streaming is the most obvious type of streaming (to which the modified section 177EA could apply), it does not represent the only type of streaming activity that an ADI could undertake. [Schedule 1, item 105, paragraph 177EA(19)(da)]

2.118 Notwithstanding this potential for streaming, it is possible that the existing anti-streaming provision in section 160AQCBA of the ITAA 1936 could apply to an ADI merely because, under this concession, non-share dividends are not frankable. To ensure that the section is not automatically triggered merely because the non-share dividends are unfrankable, the Commissioner is prevented from making a streaming determination relying solely on that fact. [Schedule 1, item 101, subsection 160AQCBA(3A)]

2.119 However, if an ADI is streaming franking credits within the terms of section 160AQCBA in a way that is not exclusively due to the fact that non-share dividends through its branch are unfrankable, the section can still apply. Moreover, if the ADI has a non-incidental purpose of streaming franking credits, the Commissioner will be able to make a streaming determination under section 160AQCBA notwithstanding that the streaming arises because the non-share dividends issued through the branch are unfrankable. [Schedule 1, item 101, subsections 160AQCBA(3B) and (3C)]

Special franking rules for non-share dividends: non-share dividends paid by certain co-operatives not frankable

2.120 Non-share dividends paid by co-operative companies eligible for tax concessions under Division 9 of Part III of the ITAA 1936 are not frankable. [Schedule 1, item 95, paragraph (da) of the definition of frankable dividend in section 160APA]

Bonus issues

2.121 The tax consequences of a company issuing bonus interests to the holders of non-share equity interests correspond to those for the issue of bonus shares. This arises because of the interaction between the provision in the ITAA 1936 governing bonus share issues (section 6BA) and the extended definitions of shares and dividends incorporating non-share equity interests and non-share distributions that apply for the purposes of that section.

2.122 Because of subsection 6BA(5) of the ITAA 1936, if the holder of a non-share equity interest has a choice to be paid a non-share dividend or to be issued with equity interests ( bonus interests ) then the non-share dividend is taken to have been credited to the holder. In other cases, the cost base of the non-share equity interests is spread over the original interest and the bonus interests in accordance with subsection 6BA(3) of the ITAA 1936.

2.123 Subsection 6BA(6) of the ITAA 1936 is a provision applicable only to actual shareholders in a public company and has no application to non-share equity holders. [Schedule 1, item 50, subsection 6BA(7) of the ITAA 1936]

Debt interests

Is there a financing arrangement?

2.124 As is the case with equity interests, the threshold question in determining whether a particular interest in an entity is a debt interest is whether the scheme giving rise to the relevant interest is a financing arrangement. If it is not, the interest cannot be a debt interest. [Schedule 1, item 34, paragraph 974-20(1)(a)]

2.125 The comments in paragraphs 2.6 to 2.9 in relation to equity interests apply equally to financing arrangements in relation to debt interests. In addition the following schemes relevant to debt interests are explicitly excluded from being financing arrangements:

•

leases that are not qualifying arrangements for the purpose of Division 16D of Part III of the ITAA 1936 and also not a relevant agreement for the purposes of section 128AC of that Act [Schedule 1, item 34, subparagraphs 974-130(4)(a)(i) and (ii)] ;

•

securities lending agreements under section 26BC of the ITAA 1936 [Schedule 1, item 34, paragraph 974-130(4)(b)] ;

•

life insurance and general insurance contracts undertaken as part of the issuers ordinary course of business [Schedule 1, item 34, paragraph 974-130(4)(c)] ; and

•

schemes for the payment of royalties within the meaning of the ITAA 1936 (other than qualifying arrangements for the purpose of Division 16D of Part III of the ITAA 1936 or relevant agreements for the purposes of section 128AC of that Act [Schedule 1, item 34, paragraph 974-130(4)(d)] .

2.126 The following discussion of debt interests in a company relates to interests arising under schemes that constitute financing arrangements.

2.127 If an interest in a company, including an interest comprising integrated related schemes (see paragraphs 2.50 to 2.58), falls within the definition of a debt interest (i.e. it satisfies the debt test) at the time it comes into existence (or at certain other times involving a material change - see paragraphs 2.129 to 2.134), then it is not an equity interest. [Schedule 1, item 34, subsection 974-70(1)]

2.128 Therefore, whether a debt/equity hybrid interest in a company satisfies the debt test will determine whether returns provided to its holder are frankable or may be deductible. The definition of a debt interest is also relevant for thin capitalisation purposes (see paragraph 3.23). For these purposes the debt test is applied to an interest issued by any type of entity, not only companies (the new equity rules are limited to companies).

Material changes to existing schemes

2.129 The determination of the character of an interest as a debt interest or an equity interest at the time it comes into existence means that, without a special rule dealing with material changes, the economic substance of an interest could be radically changed without a change to its tax treatment.

2.130 To prevent this, an equity interest that does not satisfy the debt test at the time it comes into existence will nevertheless be treated as a debt interest if there is a material change to the scheme or schemes. A material change is one that has the effect of converting the equity interest into a debt interest. An equivalent rule applies in relation to debt interests that become equity interests. [Schedule 1, item 34, section 974-110]

2.131 The material change could come about because the scheme or schemes that gave rise to the debt or equity interest is changed. In this case, the new equity or debt interest comes into existence at the time of the change. [Schedule 1, item 34, subsection 974-110(1)]

2.132 A material change could also occur because a new related scheme is entered into. In this case the new equity or debt interest comes into existence when the new scheme is entered into. [Schedule 1, item 34, subsection 974-110(2)]

2.133 In applying these tests, it is necessary to take into account all changes or new schemes entered into before the material change occurred, even if they did not themselves amount to a material change because they did not change the character of the interest from debt to equity, or equity to debt. [Schedule 1, item 34, subsection 974-110(3)]

2.134 Certain consequences arise for the non-share capital account if a debt interest changes to an equity interest, or vice versa. These are discussed in paragraph 4.7.

Example 2.12: Changing from equity to debt

A company issues a preference share which, after 5 years, is effectively converted into a 5-year bond. The so-called conversion into a bond is a material change which results in the original preference share becoming a debt interest from the time the so-called conversion takes place.

Which returns on debt interests are deductible?

2.135 The deductibility of a return on a debt interest is determined according to the general deductibility provisions of the income tax law, principally section 8-1 of the ITAA 1997.

2.136 However, returns on interests (including debt/equity hybrids) that satisfy the debt test (e.g. an interest that would be equity interests but for the fact that they satisfy the debt test such as a mandatorily redeemable preference share) may not be able to satisfy section 8-1 because they may be contingent on economic performance or may secure a permanent or enduring benefit for the company. The effect of the contingency is to prevent the return being incurred in the gaining or producing of assessable income within the meaning of section 8-1 (because it represents the application of income derived, see Commissioner of Taxation v Boulder Perseverance (1937)
58 CLR 223 ; FC of T v The Midland Railway Company of Western Australia Ltd (1951)
85 CLR 306 ). The effect of the securing of the permanent or enduring benefit may make the return capital and therefore not deductible under section 8-1.

2.137 If, but for these 2 obstacles, a return on the debt interest (including, for example, dividends on shares that satisfy the debt test) would satisfy section 8-1 then the return should be deductible up to the limit explained in paragraph 2.139. This is because of the equivalence of such returns to interest payments on a loan. To effect this, the fact that the returns on such hybrids may be contingent on economic performance, or may secure a permanent or enduring benefit, is disregarded when applying section 8-1. (Return in this context means a return on an investment rather than a return of an investment.) [Schedule 1, item 3, section 25-85]

Example 2.13: Deductibility of returns on a cumulative perpetual note

A company issuesan unsecured, subordinated perpetual note. The coupon exceeds the companys ordinary debt rate (i.e. the benchmark rate of return) by 1.5 percentage points (150 basis points) and payment is contingent on the companys profits of the previous year. Payments on the note can be deferred for up to 5 years where the profit contingency is not satisfied. Deferred payments accumulate and compound at a market interest rate and are payable at the end of 5 years irrespective of whether the contingency is satisfied or not (i.e. the company must make the payments even in circumstances where there are no available profits). The company cannot defer or waive the obligation to pay the coupons beyond 5 years.

The note is an interest of a kind referred to in item 2 of the table in subsection 153-10(1) as the returns are contingent on the companys economic performance. However, because the coupons are effectively non-contingent (see paragraphs 2.174 to 2.183), the note is a debt interest in the company under section 974-20: the company has an effectively non-contingent obligation to repay the notes subscription price through the perpetual coupons, given the obligation to pay the deferred coupons at the end of 5 years.

But for paragraph 25-85(1)(b), section 8-1 would deny a deduction for the coupons as the character of the advantage sought by the company in making the coupon payments is to secure a permanent and enduring benefit (i.e. they are of a capital nature). However, the effect of that paragraph is to disregard that fact in applying section 8-1. Assuming the other requirements of section 8-1 are satisfied, the coupons will be deductible to the company.

2.138 As a revenue safeguard it is necessary to prevent excessive deductible payments on debt/equity hybrids that satisfy the debt test. The risk to the revenue is that a company could distribute its profits as deductible payments in lieu of frankable dividends by making the distribution in respect of a hybrid that has been artificially characterised as debt. The artificiality of the characterisation would be indicated by a return on the interest considerably in excess of the interest payable on an equivalent interest without any equity component (i.e. straight debt).

2.139 Therefore the deduction for returns on debt/equity hybrids is capped by reference to the rate of return on an equivalent straight debt interest, increased by a margin to recognise the premium paid for the increased risk of non-payment because of the contingency. That rate of return is referred to as the benchmark rate of return, and the margin is 150 basis points. The margin may be increased or decreased by regulation. [Schedule 1, item 3, subsections 25-85(3) and (4)]

2.140 To determine whether this cap applies it is necessary first to calculate the annually compounded internal rate of return on the debt interest. The annually compounded internal rate of return is the same as the effective annual rate, which is the interest rate expressed as if it were compounded each year.

2.141 If this rate exceeds the benchmark rate of return (which is also annually compounded - see paragraph 2.170) then the fact that the return is contingent on profits or secures a permanent or enduring benefit is not disregarded to the extent of the excess. As a result no deduction would be available under section 8-1 to that extent.

Example 2.14: Limit to deductibility of returns on debt/equity hybrids

Under a commercial, arms length arrangement, a company issues a 10 year subordinated debenture with a face value of $1 million. The terms of issue do not allow the term of the debenture to be extended. The company is under an effectively non-contingent obligation to repay the $1 million to the debenture holder at maturity.

Coupons are payable to the debenture holder at an annual rate of 5% plus 5% of distributable profits. Distributable profits in the first year are $900,000. The companys ordinary debt rate (i.e. the benchmark rate of return) is 6% per annum.

The debenture is a debt interest in the company under section 960-202. But for section 25-85, section 8-1 would deny a deduction for the returns as they are paid out of after-tax profits at a point in time after the derivation of income. However, the effect of paragraph 25-85(2)(a) is to allow the returns to be an allowable deduction provided the other requirements of section 8-1 are satisfied.

However, subsection 25-85(3) limits how much of the $95,000 (5% of $900,000 and 5% of $1,000,000) return is deductible. The subsection denies a deduction to the extent to which the annually compounded internal rate of return exceeds the benchmark rate of return increased by 150 basis points (i.e. 7.5% in this case).

The annually compounded internal rate of return is 9.5% (i.e. the annual internal rate of return assuming payments of $95,000 per annum) Therefore a deduction is denied for 2% of $1 million, namely $20,000. Thus only $75,000 of the $95,000 return is deductible.

What interests have a term in excess of 10 years?

2.142 If an interest to which the debt test applies has a term in excess of 10 years then a calculation of the present value of certain amounts is required. Thus, to apply the debt test to an interest it is first necessary to determine whether it has a term in excess of 10 years.

2.143 An interest has a term in excess of 10 years if its performance period exceeds 10 years. The performance period is the period within which the issuer of the interest (or, if relevant, the issuers connected entity) has to meet its obligations in relation to the interest. [Schedule 1, item 34, subsection 974-35(3)]

2.144 An obligation under an interest has to be met within 10 years if there is an effectively non-contingent obligation (as explained in paragraphs 2.174 to 2.183) to terminate the interest within that period. This is the case even if the terms of the interest nominally allow it to remain extant for more than 10 years. [Schedule 1, item 34, subsection 974-35(4)]

2.145 A termination can occur in a number of ways, including by discharging an obligation or converting an interest into another interest. Sections 974-40 and 974-45 explain termination events. [Schedule 1, item 34, sections 974-40 and 974-45]

2.146 For example, a nominally perpetual instrument which may be redeemed by the issuer at any time will have a term of 10 years or less for the purposes of the debt test if the issuer is effectively obliged to redeem the interest within that time because the terms of issue require an economically unsustainable step-up in the return on the interest if the interest is not redeemed after 5 years.

2.147 It is necessary to have regard to all the circumstances when considering whether a step-up in the return on a particular interest is economically unsustainable, thereby rendering a termination of an interest effectively non-contingent. However, as a general rule, the level of permissible step-up provided by the APRA for Tier 1 capital instruments issued by APRA regulated institutions (e.g. Australian banks) would be economically sustainable. Step-ups in excess of that would usually, depending on the circumstances, be unsustainable for those institutions.

What is a debt interest?

2.148 The meaning of a debt interest is determined generally in accordance with the tests contained in Subdivision 974-B. To promote certainty and facilitate the categorisation of new types of financial instruments as debt or equity, the tests provided in the Subdivision may be modified or supplemented by the regulations. [Schedule 1, item 34, subsection 974-10(5)]

2.149 A scheme or a number of integrated related schemes gives rise to a debt interest if, when it comes into existence, it satisfies the debt test. [Schedule 1, item 34, subsections 974-15(1) and (2)]

2.150 The debt test provides that a debt interest arises under a scheme if:

•

the scheme is a financing arrangement or is one that constitutes a share;

•

an entity or associate receives or will receive a financial benefit(s) under the scheme;

•

the entity or a connected entity has an effectively non-contingent obligation under the scheme to provide a financial benefit(s) in the future; and

•

it is substantially more likely than not that the value of the financial benefit(s) to be provided will equal or exceed the value of the financial benefit(s) received (depending on the term of the scheme, the relevant values may be calculated in nominal value or present value terms).

[Schedule 1, item 34, subsection 974-20(1)]

2.151 The focus of the debt test on the effectively non-contingent obligations of the issuer (rather than on the ability of the investors to recover their investment) is consistent with accounting standards and the regulatory regime for Australian ADIs.

2.152 An exception to the debt test is made for cases where an entity receives a financial benefit other than money or other liquid assets and is obliged to, and does, provide a financial benefit in return (or the transaction is otherwise settled) within 100 days. For example, the supply of goods on terms allowing 100 days to pay will not give rise to a debt interest if payment is made on time. [Schedule 1, item 34, subsection 974-25(2)]

2.153 This exception may be supplemented or modified by regulations. The regulations may, for example, provide guidance on when a financial benefit is, or is not, a monetary or liquid asset. Generally speaking, a liquid or monetary asset is an asset that is cash or readily exchangeable into cash. Examples include most listed company shares, foreign currency and negotiable bills of exchange. [Schedule 1, item 34, subsection 974-25(3)]

2.154 Another exception relates to the non-arms length arrangements explained in paragraphs 2.61 to 2.66. Notwithstanding that such arrangements may nominally satisfy the debt test, they will not constitute a debt interest if they otherwise fall within the definition of an equity interest and would have been equity interests if the relevant scheme had been undertaken on an arms length basis. Of course, not all non-arms length arrangements would otherwise be equity interests (those that would not will be debt if they satisfy the debt test). However, those which provide returns contingent on the economic performance of the issuer, or which are convertible into equity interests, would remain equity interests if they would have been had the arrangement been at arms length. [Schedule 1, item 34, subsection 974-25(1)]

2.155 If a particular scheme constitutes a debt interest then the debt interest consists of the interest that carries the right corresponding to the relevant effectively non-contingent obligation. The interest is taken to have been issued when the issuer (i.e. the entity that has, or whose connected entity has, the effectively non-contingent obligation referred to in paragraph 2.172) first receives a financial benefit under the scheme. It remains on issue for as long as an obligation under the scheme remains outstanding. [Schedule 1, item 34, subsection 974-55(1)]

2.156 If a debt interest contains obligations by more than one entity it is necessary to determine which entity is the issuer of the interest. Subject to an over-riding discretion of the Commissioner to determine who is, in economic substance, the issuer of the interest, it is the entity with the greatest total value of obligations that is taken to be the issuer. [Schedule 1, item 34, section 974-60]

Example 2.15: Determining the issuer of a debt interest

Two companies in a wholly-owned group enter into a scheme that is a scheme that is financing an arrangement under which the first company obtains $1 million and is obliged to repay it in 5 years, and the second company is obliged to pay interest of 8% per annum during that 5 year period.

As the scheme has a performance period of 5 years the obligation value of each entity is to be calculated in nominal terms.

As the first entity has an obligation both in legal form and in economic substance to repay $1 million it has an obligation value of $1 million. The second entity has an obligation both in legal form and in economic substance to pay interest of $400,000 (i.e. $80,000 5) during the performance period.

Unless the Commissioner determines otherwise, the first company is taken to be the issuer of the debt interest because its obligation value of $1 million is greater than the obligation value of $400,000 of the second company.

2.157 The constituent elements of the debt test are explained in paragraphs 2.158 to 2.206.

First element: there needs to be a scheme which is a financing arrangement

2.158 A scheme is a financing arrangement if it satisfies the definition of that term. See paragraphs 2.6 to 2.9.

2.159 A scheme is defined broadly in subsection 995-1(1) of the ITAA 1997 to include formal and informal agreements, arrangements and understandings that are not legally binding. A simple example of a scheme is the issue of a debt/equity hybrid instrument by a company (e.g. a redeemable preference share).

2.160 The concept of a scheme allows the linking of the receipt of a benefit and the obligation to make a payment in determining whether a debt interest exists. In certain cases the Commissioner may determine that a single scheme reflects, in economic substance, disparate schemes and may therefore exercise a discretion to disaggregate it. [Schedule 1, item 34, subsection 974-150(2)]

2.161 Related schemes may be integrated in an equivalent way to that described in relation to equity interests in paragraphs 2.50 to 2.60. Consistent with the integration test for equity interest, related schemes that individually constitute debt interests will not be integrated to form a single debt interest, and the Commissioner may determine not to integrate related schemes. [Schedule 1, item 34, subsections 974-15(2) to (4)]

2.162 If an interest that would be an equity interest by itself is one of a number of related schemes that together satisfy the debt test then it will not be an equity interest. For example, if a company issues an ordinary share and, under a related scheme, guarantees to repay the issue price after 5 years, the ordinary share will not be an equity interest if the related schemes of the share and the guarantee together constitute a debt interest.

Second element: there needs to be the receipt of a financial benefit under the scheme

2.163 For a scheme to be a debt interest there must first be the receipt, now or in the future, of a financial benefit by an entity (e.g. the issue price of a debt/equity hybrid interest). [Schedule 1, item 34, paragraph 974-20(1)(b)]

2.164 In the simplest case of a debt interest, this financial benefit would be a sum of money, which the entity is obliged to repay (with interest). However, financial benefit is defined broadly to mean anything of economic value, including property or services [Schedule 1, item 34, subsection 974-160(1)] . Moreover, the fact that the receipt of property or services may be accompanied by an obligation to repay it does not prevent it constituting a financial benefit. Instead, in this respect the receipt and the obligation will be separate financial benefits (i.e. they are to be looked at separately and not offset against each other in determining whether there is a financial benefit) [Schedule 1, item 34, subsection 974-160(2)] . A financial benefit may also comprise a reduction of a liability or deferral of a payment. For example, if a taxpayer owes money that is due and payable, non-payment of that money constitutes a financial benefit because of the time value of money. Example 2.17 shows how a debt interest may arise because of the non-payment of money due.

2.165 The initial receipt of a financial benefit under an arrangement may also involve the provision of a financial benefit at the same time. In determining the value of the financial benefit received the value of the benefit provided would be offset against the value of the benefit received. Financial benefits provided or received at the same time may be offset in determining their value for the purposes of applying the debt test (but not in determining whether a financial benefit arises).

Example 2.16: Exchange of financial benefits

A company obtains goods valued at $1,000 on credit and at the same time pays an instalment to the provider of the goods of $200. Under the terms of the credit arrangement the company is required to pay a final instalment of $900 in 2 years time. The value of the financial benefit received under the scheme is taken to be $800. As the company has an effectively non-contingent obligation to provide $900 in the future the scheme satisfies the debt test as the value of the financial benefits to be provided at least equals the value of the financial benefit received.

2.166 The financial benefit received does not have to be an immediate one, but could be a financial benefit to be received (in the sense of there being an effectively non-contingent obligation by an entity to provide it) in the future, and could comprise a number of financial benefits (e.g. the payment of the issue price of a debt/equity hybrid interest in instalments). In such cases, the value of all the benefits is taken into account in determining the total value of financial benefits received or to be received under the scheme. [Schedule 1, item 34, subsections 974-20(2), (4) and (5)]

Example 2.17: Benefit received over time

A company issues an instrument which it calls an instalment bond with an issue price of $100, payable in 2 instalments. The first instalment of $50 is to be paid on issue; the second $50 instalment is payable one year later.

The issue of the bonds constitutes a scheme under which the company has received financial benefits equal to $100.

Calculating the benefit in present value terms

2.167 The following discussion of calculating benefits in present value term is equally relevant to benefits to be received and benefits to be provided.

2.168 If the financial benefit is to be provided in the future then its present value needs to be calculated if the performance period of the relevant scheme exceeds 10 years (as explained in paragraphs 2.142 to 2.147). [Schedule 1, item 34, subparagraph 974-35(1)(a)(ii)]

2.169 Section 974-50 explains how to calculate the present value of a financial benefit. The calculation of the value of a financial benefit in present value terms is, subject to the regulations, based on the assumptions that the interest is held until maturity and all payments are paid at the earliest time that the issuer becomes liable to pay them. Thus, for example, if a company is liable to provide a return on a particular day then it is taken to be paid on that day for the purpose of calculating its present value even if, under the terms of the relevant instrument, payment may be deferred. Of course, it is a question of fact as to when a company is actually liable to pay an amount: in this regard the nominal date for when a liability arises would not be conclusive if the circumstances indicate that the liability actually arises at a different time. [Schedule 1, item 34, subsections 974-35(2) and 974-50(3)]

2.170 The formula for calculating the present value of a financial benefit provides for the nominal value of the financial benefit to be discounted using the adjusted benchmark rate of return . This is defined as 75% of the benchmark rate of return which, in turn, is defined as the internal rate of return on an investment if the investment were ordinary debt of the issuer or an equivalent entity, compounded annually and otherwise comparable with the interest under consideration. Ordinary debt entails no contingent payments. [Schedule 1, item 34, subsection 974-50(4), sections 974-140 and 974-145]

2.171 See Examples 2.21 and 2.22 for a practical application of the present value formula and paragraph 2.192 for an explanation of the 75% figure. Regulations may prescribe an alternative way of calculating the value of financial benefits. [Schedule 1, item 34, subsections 974-50(5) and (6)]

Benefits of connected entities

2.172 Because a benefit received by a connected entity of an entity can be equivalent to a benefit received by the entity itself, the receipt of a financial benefit element of the debt test is satisfied if the financial benefit is received by the entity or by a connected entity of the entity.

Regulations

2.173 The regulations may provide how to calculate the value of financial benefits received, and also what the financial benefit is and when it arises. [Schedule 1, item 34, subsections 974-50(6) and 974-160(3)]

Third element: there needs to be an effectively non-contingent obligation to provide a financial benefit in the future

2.174 Debt in a formal sense involves obligations which are non-contingent in legal form (e.g. a legal obligation to pay interest and to return principal). However, if the debt test were to focus solely on obligations which are non-contingent in legal form, schemes that are equivalent in economic substance might give rise to different tax outcomes. This would encourage tax arbitrage and open up tax avoidance opportunities.

2.175 The debt test therefore uses the concept of an effectively non-contingent obligation as opposed to a legally (or formally) non-contingent obligation. Thus a scheme under which an entity has a right but not a legal obligation to provide a financial benefit could nevertheless be debt if, having regard to the pricing, terms and conditions of the scheme, the entity is in substance or effect inevitably bound, to exercise that right. This would occur where not to exercise the right would result in the entity having to sustain a greater loss (in present value terms) from the scheme than if it exercised the right. A simple example of this would be where the issuer of a financing instrument has a right to redeem it after a certain period but is compelled to provide accelerating returns on the instrument if it does not exercise that right: the accelerating returns would make it uneconomic for the issuer not to redeem the instrument so that it is under an effectively non-contingent obligation to do so.

2.176 The concept of an effectively non-contingent obligation is, however, not intended to displace regard to legal rights and obligations. This is particularly so where those rights and obligations are consistent with arms length transactions of commercial substance and reflect the clear intention of the parties.

The meaning of effectively non-contingent

2.177 There is an effectively non-contingent obligation to provide a financial benefit for these purposes if, having regard to the practical or economic consequences of not providing the benefit, there is in substance or effect an obligation to provide that benefit. [Schedule 1, item 34, subsection 974-135(1)]

2.178 Determining whether or not this is the case in a particular set of circumstances, is to be guided by the rationale for having an effectively non-contingent concept rather than simply a formal non-contingent test (i.e. where any form of contingency, whether artificial or not, would be sufficient to prevent the obligation being non-contingent). In this regard, reliance solely on a formal non-contingent test would enable taxpayers to easily impose artificial contingencies in order to prevent an interest being debt. In addition, consistent with the principle inherent in the debt test of focusing on economic substance rather than legal form, where a contingency is so remote as to be effectively inoperative (immaterially remote) it is as if the contingency did not exist and it should be disregarded.

2.179 In some circumstances it will be clear that a particular contingency is immaterially remote for these purposes. These will be cases where there is only a theoretical rather than a real possibility of the contingency occurring. In other cases it will be necessary to be guided by the purpose underlying a particular contingency: if the evidence indicates that a contingency is an artificial one used to disguise the inherent non-contingent substance of an obligation then it will be effectively non-contingent for the purposes of the debt test. This approach ensures debt cannot be disguised by inserting an immaterial contingency. [Schedule 1, item 34, subsection 974-135(6)]

2.180 In summary, therefore, the effectively non-contingent test identifies formal contingencies attached to a right that are:

•

manifestly so remote as not to be real because they have only a theoretical rather than a real possibility of occurring; or

•

artificial contingencies disguising the inherent non-contingent character of a particular right which are imposed to avoid the interest being classified as debt.

2.181 Conversely, the effectively non-contingent test also identifies formally non-contingent obligations that, having regard to the circumstances of the scheme, are such that there is no non-contingent obligation as a matter of substance or effect. This may be the case, for example, where related parties enter into formally binding obligations which, because of matters such as the relationship between the parties, are in substance or effect not obligations at all because failure to perform the so-called obligation will have no practical consequences. This can be contrasted with ordinary cases involving formally non-contingent obligations, where failure to perform an obligation would expose the non-performer to legal or economic sanctions.

2.182 Regulations may be made to supplement, and provide guidance as to, the meaning of effectively non-contingent obligations. Among other things, this will enable certainty to be provided for particular types of arrangements - specifying whether they do, or do not, constitute debt. Factors relevant to the making of such regulations may include:

•

the individual circumstances of the parties to the arrangement, including their purpose or purposes in relation to the arrangement;

•

whether the contingencies and non-contingent obligations are artificial or immaterially remote;

•

financial analysis;

•

the type of arrangement, including the nature of the rights, obligations, assets and liabilities in respect of the arrangement; and

•

the level of return provided.

[Schedule 1, item 34, subsection 974-135(8)]

2.183 The regulations will enable, for example, clarification of the circumstances in which so-called interest-free debt does not give rise to an effectively non-contingent obligation for the purposes of determining what constitutes a debt interest.

A benefit to be provided in the future

2.184 In one sense, an obligation to provide a benefit in the future to someone represents a present benefit to that person (because the person is assured of getting a benefit later on). However, that is not the sense in which the provision of a benefit in the future is to be read for the purposes of the debt test. For those purposes a present obligation to provide future benefits is disregarded, and the focus is on those future benefits. [Schedule 1, item 34, subsection 974-30(3)]

2.185 The financial benefit to be provided in the future may be provided to any entity. There may be one or more benefits. If there is more than one benefit then the sum of those benefits is taken into account. [Schedule 1, item 34, subsections 974-20(3) and (5)]

2.186 Usually it will be provided to the entity from whom a financial benefit was received. However, it could also be provided to a connected entity of that entity, or even an unrelated third party. A benefit can be provided to an entity by applying it on the entitys behalf. [Schedule 1, item 34, subsection 974-30(2)]

2.187 The financial benefit may be money, other property, services, or anything else of economic value. [Schedule 1, item 34, section 974-160]

2.188 However, the provision of equity interests in the issuer or a connected entity does not count. Nor does the provision of an amount of money that is to be applied in respect of the issue of such equity interests. [Schedule 1, item 34, subsection 974-30(1)]

Example 2.18: Converting preference shares

A company issues CPS which convert at the end of their term into a number of ordinary shares whose total value is at least equal to the issue price of the CPS. The terms of issue are such that the holder of the CPS has a real likelihood of making a gain from the conversion because the value of an ordinary share on conversion may exceed the CPS price.

The CPS are not debt. Although the value to be returned to the investor at least equals the investment amount, that value is returned in the form of equity interests (ordinary shares), which are disregarded. The outcome would be different if the CPS converted, in a loose sense of that term, into shares of an unconnected company: in that case other property is being provided which at least equals the investment amount, so the debt test would be satisfied.

Example 2.19: Convertible note with two-step conversion

A company issues a convertible note on terms that define the word convert as the repayment of the face value of the note to the holder and the subsequent application of those proceeds towards the subscription of shares in the company. Under the terms of the instrument, this conversion is mandatory.

The repayment of the face value in these circumstances does not result in an effectively non-contingent obligation to provide a financial benefit of that amount. This is because paragraph 974-30(1)(b) provides that there is no such obligation where the benefit to be provided is an amount that is to be applied in respect of the issue of an equity interest in the company.

2.189 The regulations may provide what a financial benefit is and when it arises for these purposes. [Schedule 1, item 34, subsection 974-160(3)]

2.190 The requirement that the financial benefit be provided in the future means that transactions where a financial benefit is received contemporaneously with the provision of a financial benefit will not constitute a debt interest. For example, a simple conversion of currency whereby Australian dollars are exchanged for foreign currency will not constitute debt because the obligation to pay Australian dollars is contemporaneous with the receipt of the financial benefit (the foreign currency).

2.191 As with the value of financial benefits received, the value of financial benefits to be provided in the future is to be determined in:

•

nominal value terms if the performance period is 10 years or less; or

•

present value terms if the performance period is greater than 10 years.

[Schedule 1, item 34, paragraph 974-35(1)(a)]

2.192 As explained in paragraphs 2.168 and 2.169 a future benefit which is subject to the present value test is taken to be equivalent to a benefit which is received today and reinvested at a compounding rate of return equal to 75% of the ordinary debt rate of the relevant company. The 75% reflects the fact that the equity component of a debt/equity hybrid interest will, in a sense, be paid for by a lower guaranteed (i.e. effectively non-contingent) return than that on a straight-debt interest (i.e. an interest without any equity component). If this were not the case the investor would be getting the equity component of the hybrid without paying for it. Therefore, if the full ordinary debt rate was used, the present value of effectively non-contingent future benefits paid on debt/equity hybrids could be expected always to be less than the amount paid for them, preventing all hybrids to which the present value test applies satisfying the debt test. Using only 75% of that rate ensures a small equity component of a debt/equity hybrid will not preclude the hybrid from satisfying the debt test.

2.193 Sometimes it is necessary to calculate the present value of an indefinite number of returns because the instrument is perpetual. For example, a note may provide for a specified annual return to be paid perpetually. In cases like these where the value or amount of the financial benefit received is the same for each year, as the term n in the formula in subsection 974-50(4) approaches infinity the total value of the returns on a present value basis can be approximated as:

amount or value of financial benefit in nominal terms / adjusted benchmark rate of return


Example 2.20: Benefits to be provided calculated in nominal value terms

Assume in Example 2.17 that the instalment bonds are issued on terms requiring the payment of annual interest of 5% and compulsory redemption after 5 years for their issue price.

At the time of issue of the bond, the company has an effectively non-contingent obligation (because in form and substance there is an actual legal obligation) to provide a financial benefit in the future, namely the interest payments and the redemption proceeds. The value of the financial benefit to be provided is therefore the nominal value of the sum of the 5% annual returns and the issue price.

Example 2.21: Benefits to be provided calculated in present value terms

A company issues convertible notes for $9 each on 1 July 2001. The notes provide a coupon of 7% paid once a year (on 1 July). Each of the notes may be converted into 2 ordinary shares on 30 June 2016. Assume that the benchmark rate of return of the company is 8%.

On the assumption that the convertible note will be held until maturity, there will be 15 coupon payments of $0.63 ($9 7%) and a return of the principal of $9 at maturity. The value of the financial benefit provided will be the sum of the present value of these benefits discounted using an adjusted benchmark rate of return of 6% (8% 75%) and 15 interest periods.

Using present value calculation methods, the value of financial benefits to be provided is calculated as follows:

$0.63 / (1.06)^1 + $0.63 / (1.06)^2 ... + $9.63 / (1.06)^15
= $9.87


Therefore, because the present value of the financial benefits to be provided in the future exceeds the issue price of the notes, the notes constitute debt interests.

Example 2.22: Calculating present value for perpetual instruments

A company issues undated notes for $9 each on 1 July 2001. The notes provide a coupon of 7% paid once a year. Assume that the benchmark rate of return of the company is 6%.

The value of the financial benefit provided will be the sum of the present value of these financial benefits discounted using an adjusted benchmark rate of return of 4.5% (6% 75%).

The present value of the value of financial benefits to be provided is approximated as follows:

$0.63 / 0.045
= $14.00


Therefore, because the present value of the financial benefits to be provided in the future exceeds the issue price of the notes, the notes constitute debt interests.

2.194 When calculating the total value of financial benefits received, it is necessary to assume that the scheme will continue to be held for the rest of its life. Thus the fact that the issuer may have an option to terminate the scheme early does not prevent the consideration of financial benefits to be provided after that optional termination time. [Schedule 1, item 34, subsection 974-35(2)]

2.195 However, if a party to the scheme has a right or option to terminate it (including by discharging an obligation early or by converting it into another interest) and the relevant circumstances of the scheme indicate that there is an effectively non-contingent obligation to exercise that right or option at a particular time, the life of the interest is taken to end at that time. An example of this is where the issuer has a right to redeem an interest after 5 years, or to leave the interest on issue and pay a commercially unsustainable return on it. In this case the issuer has an effectively non-contingent obligation to redeem it after 5 years, and that is when the life of the interest will be taken to end. [Schedule 1, item 34, section 974-40]

Fourth element: it must be substantially more likely than not that the financial benefit to be provided will at least equal the value of the financial benefit received

2.196 For the debt test to be satisfied, the financial benefit to be provided under the scheme must at least equal the financial benefit received or to be received. [Schedule 1, item 34, paragraph 974-20(1)(d)]

Expected value

2.197 The debt test does not generally require an assessment of expected value. Thus, where there is no effectively non-contingent obligation to provide a financial benefit, the fact that it might be reasonable to expect a financial benefit of a certain amount would be provided is not relevant. For this reason, returns which, for commercial reasons, are contingent on the availability of profits of an entity would generally not be counted in determining whether the debt test is satisfied, even if the possibility of not having profits is slight.

2.198 In some circumstances, however, the value of a financial benefit to be provided in the future, although non-contingent, will be uncertain. Because it is non-contingent it is necessary to count it in determining whether the debt test is satisfied, and this presents a problem if its value is uncertain.

2.199 If the value of that benefit depends on a variable in general commercial use whose future value it is not possible to predict with sufficient certainty (e.g. a floating interest rate), the current value of that variable is used to calculate the future benefit. For example, a non-contingent return in 5 years based on the 90-day bank bill rate existing at that time will be calculated on the basis of the prevailing rate at the time of the relevant interests issue. [Schedule 1, item 34, subsection 974-35(5)]

2.200 In other cases, it is necessary to make an assessment of whether it is substantially more likely than not that the financial benefit to be provided will at least equal the financial benefit received. However, subject to the Commissioners power to make a determination, only financial benefits provided under an effectively non-contingent obligation need to be considered for these purposes: contingent benefits are not subject to this test even if they are likely to be made. [Schedule 1, item 34, paragraph 974-20(1)(d)]

2.201 Regulations may be made prescribing what substantially more likely than not means in this context. Subject to those regulations it means that the likelihood of the financial benefit to be provided being at least equal to the amount invested has to be not merely more likely than not, it has to be substantially more likely than not. This does not, however, mean that it has to be highly likely that the financial benefit to be provided at least equals the amount invested. [Schedule 1, item 34, subsection 974-20(6)]

Example 2.23: Indexation

A company issues an inflation-indexed bond that provides an effectively non-contingent return equal to the issue price indexed to inflation.

Technically, inflation can be negative (i.e. deflation is possible). Therefore, it would be theoretically possible for the bond to provide a return less than its issue price (in which case it would not be debt). However, deflation is a very rare occurrence in an economy like Australias and, for practical purposes, the possibility of it occurring can be ignored. Therefore, because it is substantially more likely than not that the return on the bond will at least equal its issue price, it is debt.

Expressing financial benefits in foreign currency

2.202 If the financial benefit received is expressed in a foreign currency and the financial benefit to be provided is expressed in the same terms, then the debt test can be applied using the foreign currency to ascertain whether the financial benefits are equal or not. [Schedule 1, item 34, subsection 974-35(6)]

Example 2.24: Debt expressed in foreign currency or other units of measure

An Australian company borrows $US1 million to be repaid (in US dollars) over 5 years. This constitutes debt notwithstanding that changes in the US dollar exchange rate may mean that, in Australian dollar terms, the company pays back less than the amount borrowed. (The outcome would be the same if the loan were expressed in, for example, ounces of gold.)

Commissioners power to determine that a scheme gives rise to a debt interest

2.203 Because the debt test is generally not based on expected value, it is susceptible to the creation of artificial schemes designed to convert what would otherwise be debt into an arrangement that, technically, does not satisfy the general debt test. Such an arrangement would entail:

•

an effectively non-contingent obligation to provide a financial benefit constituting a substantial part of the financial benefit received; and

•

contingent, but likely, financial benefits that, when combined with the effectively non-contingent payments, are expected to equal or exceed the financial benefit received.

2.204 To prevent avoidance arrangements of this kind the Commissioner may, having regard to specified factors, treat certain schemes as debt, but only if:

•

the financial benefit provided pursuant to an effectively non-contingent obligation under the scheme constitutes a substantial part of the financial benefit received under the scheme;

•

it is substantially more likely than not that other financial benefits will be provided under the scheme; and

•

the sum of those other benefits and the financial benefits provided under the effectively non-contingent obligation is substantially more likely than not to equal or exceed the amount received.

[Schedule 1, item 34, subsection 974-65(1)]

2.205 In making this determination, the Commissioner must have regard to the following factors:

•

the value of the financial benefit to be provided under the effectively non-contingent obligation relative to the financial benefit received;

•

the degree of likelihood of the other financial benefits being made; and

•

the individual circumstances of the parties to the scheme, including the purpose or purposes for entering into it.

[Schedule 1, item 34, subsection 974-65(2)]

2.206 As the exercise of the Commissioners discretion will directly affect an entitys assessment, a person who is dissatisfied with the Commissioners decision may object against it under Part IVC of the TAA 1953.

Example 2.25: Exercise of Commissioners discretion

A profitable Australian company with retained earnings issues a redeemable security to its parent. Under the terms of issue of the security, the Australian company is obliged to redeem it for 99% of its issue price in 5 years time, and must pay annual returns of 10%, subject to profits being available.

Because the financial benefit to be provided under the effectively non-contingent obligation does not quite equal the amount received by the Australian company (i.e. the issue price of the security), the security does not satisfy the terms of the general debt test. However, having regard to the artificiality of the scheme, its purpose, and the likelihood of annual returns being paid sufficient to make up the shortfall, the Commissioner could make a determination that the security be treated as debt.

Examples of applying the debt test to debt/equity hybrids

2.207 Examples 2.26 to 2.28 show how the debt test combines with the definition of equity interests to determine whether a particular debt/equity hybrid is to be accorded debt or equity tax treatment.

Example 2.26: Perpetual convertible notes

A company issues perpetual convertible notes on 1 July 2001 for $9 each. The notes have coupons of 7% which are paid annually on 1 July. The obligation to pay the coupons is not subject to any contingency and cannot be deferred or waived in any circumstance. The company may, at its option, redeem the notes, or convert them into ordinary shares, at any time after 1 July 2007. The companys benchmark rate of return is 8% per annum.

Because the notes are convertible, they will represent an equity interest unless the debt test is satisfied (the scheme is a commercial arrangement at arms length).

Under the relevant scheme, the company has received a financial benefit - the issue price of $9. Making the required assumption that the notes are held for the rest of their lives, the company has an effectively non-contingent obligation to pay 7% annually in perpetuity to the note holder. The value of this benefit to be provided is calculated in present value terms as the performance period is more than 10 years (it is assumed that, while there is an option to redeem, there is no effective non-contingent obligation to do so).

The total present value of the financial benefit to be provided by the company in relation to each note is calculated as follows:

•

the coupon amount per coupon period is $0.63 ($9 7%);

•

the adjusted benchmark rate of return per period is 6% per annum compounded annually (8% 75%), or 0.06; and

•

therefore, the value of the financial benefit to be provided by the company is $10.50 ($0.63 0.06, which is an approximation of the present value formula in subsection 974-50(4) for a perpetuity).

Since the value of the financial benefit to be provided ($10.50) exceeds the value of the financial benefit received ($9), the convertible note is a debt interest. Therefore, the returns to the note holder will not be frankable and will be deductible if they satisfy the general deduction provisions of the income tax law.

Example 2.27: Converting preference shares

On 1 July 2001, a company issues CPS with a term of 15 years for $100 each. The shares pay annual dividends of 7.5%.

Conversion is mandatory after 15 years, but the company has the option to buy back the shares on 1 July 2006.

The companys benchmark rate of return is 8% per annum.

Because the holders of the CPS are shareholders in the company, they constitute equity interests unless the debt test is satisfied (the scheme is a commercial arrangement at arms length).

Under the relevant scheme, the company has received a financial benefit - the issue price of $100. However, the company does not have an effectively non-contingent obligation under a scheme to provide a future financial benefit because the payment of a dividend is contingent on profits, and the issue of ordinary shares is specifically excluded as being the provision of a financial benefit. (It is assumed that there is nothing to suggest that the company would be effectively obliged to buy back the CPS before conversion - if that were the case then the buy back price would be an effectively non-contingent return.)

Because there are no effectively non-contingent returns which are to be taken into account, the CPS do not satisfy the debt test and therefore constitute equity interests. As a result, the coupon payments will, subject to the rules governing frankability of dividends, be frankable but not deductible.

Example 2.28: Income securities

A company issues income securities on 1 July 2001 with an issue price and face value of $100.

Each income security can be redeemed (at the issuers, but not the holders, option) after 1 July 2006 at face value plus accrued interest. The coupon will float at a margin of 250 basis points above the 90-day Bank Bill rate. Coupon payments are conditional on the company having sufficient profits to support those payments.

The income securities are stapled securities comprising a fully paid $100 perpetual note and an unpaid preference share that cannot be traded separately. Under certain prescribed circumstances, the note will be cancelled and the $100 issue price used to pay up the preference share. The preference share thereupon commences to pay a dividend on the same terms as the note.

Because the income securities provide a return contingent on economic performance of the issuer (profitability), they will represent an equity interest unless the debt test is satisfied (the scheme is a commercial arrangement at arms length).

Under the relevant scheme, the company has received a financial benefit - the issue price of $100. However, the company does not have an effectively non-contingent obligation under a scheme to provide a future financial benefit because the coupon payments are contingent on profits, and there is no effectively non-contingent obligation to repay the principal. Subsection 974-135(7) provides that an obligation will not be effectively non-contingent merely because the failure to satisfy the obligation will result in detrimental practical or commercial consequences.

Because there are no effectively non-contingent returns, the income securities do not satisfy the debt test and therefore constitute equity interests. As a result the coupon payments will, subject to the rules governing frankability of dividends, be frankable but not deductible.

Some examples of non-hybrid debt interests

2.208 Examples 2.29 to 2.36 provide a selection of non-hybrid interests that constitute debt. It is not intended to be exhaustive. Whether the type of interest described in each example is debt or not is determined by reference to its terms and substance rather than how it is described. Interests in these examples are debt for the purposes of the thin capitalisation regime.

Example 2.29: Non-payment of money due

A company has an obligation under a lease to pay interest on overdue rent. The company fails to make a rental payment on time.

In this case there is a scheme (the lease agreement) that is a financing arrangement under which the company has received a financial benefit (the use of funds represented by the overdue rental payment) and has an effectively non-contingent obligation to provide a financial benefit in the future to the lessor (i.e. to pay the overdue rent with interest). Because interest is charged, the benefit to be provided by the company to the lessor exceeds the benefit it received from the non-payment of the rent. Therefore, a debt interest has been created.

Example 2.30: Embedded debt

A company acquires an item of plant with a market value of $1 million for $1.05 million to be paid over 6 months.

Although there is no explicit debt component in this transaction, there is an embedded debt reflected in the premium paid for the asset. Because there is an effectively non-contingent obligation to pay the $1.05 million (which exceeds the $1 million benefit received), the debt test is satisfied. (Note that, if payment was made within 100 days, the arrangement would be specifically excluded from being debt.)

Example 2.31: Project finance

Project finance typically involves the provision of finance on a limited recourse basis to a mining venture. Although the terms of the particular arrangement will determine whether the arrangement gives rise to a debt interest, the project finance arrangements described in this example are indicative of debt interests.

Under a production payment arrangement, a financier buys a right to future sales proceeds of minerals from a specified mine. The financier is entitled to sales proceeds sufficient to cover its investment plus accrued interest; when the arrangement is entered into, the value of the mines proven mineral reserves substantially exceed this amount. The financiers rights are limited to the mining ventures assets. At the same time, parties to the mining venture or associated parties guarantee minimum production levels.

Under a production-backed loan, a financier lends a gold mining venture a specified amount of gold, sells the gold on behalf of the venture and gives the proceeds to the venture. The venture is required to repay the amount of gold plus interest, which is denominated in gold. The venture has proven gold reserves that substantially exceed the amount it owes plus interest. The financiers rights are limited to the mining ventures assets. At the same time, parties to the mining venture or associated parties guarantee minimum production levels. Using gold as a unit of account for the purpose of determining whether an arrangement gives rise to a debt interest, the value of the financial benefit to be provided by the venture at least equals the value of the financial benefit it received.

Further clarification of the treatment of such arrangements can be provided by regulations under subsection 974-135(8) of the ITAA 1997 concerning what constitutes an effectively non-contingent obligation.

Example 2.32: Securitisation

As part of a securitisation of a pool of debt interests, a SPV of an Australian ADI, typically a trust, issues a number of foreign currency denominated long term FRNs to non-resident investors. The SPV generally has an option to redeem the securities after a specific date or earlier for a specified contractual condition.

The total of the issue prices of all the FRN is the present value of the expected future cash flows from the pool of debt interests, net of administration (including payments for provision of credit enhancement) and set-up costs. Investors are entitled to a return of the issue price of each security plus interest thereon. The investors rights are limited to the pool of debt interests. However, the investors have the benefit of a credit enhancement arrangement that insures against the risk of default in respect of the pool of debt interests.

Each security issued by the entity would give rise to a debt interest. The absence of the credit enhancement arrangement would not necessarily lead to a different result. It could be expected that often it would not do so. However, there may be a need for a greater level of enquiry of the particular circumstances (e.g. the nature of the assets underlying the debt interests; the terms, conditions and pricing of the arrangements; and other relevant factors) to determine whether it is substantially more likely than not (as explained in paragraphs 2.196 to 2.201) that the value of the pool or the redemption price will at least equal the issue price of the securities.

Regulations can be made under subsection 974-135(8) of the ITAA 1997 to provide further clarification of what constitutes an effectively non-contingent obligation for the purpose of securitisation arrangements.

Example 2.33: Sale and repurchase agreement

An entity sells to an investor for $9.5 million now, a right to receive $10 million worth of widgets in one year. The entity enters into a separate agreement to buy back that right in one year for $10 million.

The combined effect of the 2 related schemes is that the entity receives $9.5 million now and has an effectively non-contingent obligation to pay $10 million in one year. The schemes are taken to give rise to a debt interest because they are related schemes (see subsection 974-15(2) of the ITAA 1997.

Example 2.34: Bailment floor plan

A bailment floor plan has the following features:

•

A finance company buys cars from a car manufacturer/distributor that a car dealer orders. The cars are delivered to the dealer. Call the price the manufacturers price.

•

The dealer comes under an obligation to pay the finance company the manufacturers price at the end of the bailment period.

•

During the bailment period, which is the time from when the dealer takes possession of the car until it is sold, the dealer pays the finance company an amount which reflects the manufacturers price, prevailing interest rates and the bailment period. In essence, the payment(s) functions as interest on a loan. (The dealer may also reimburse the finance company for any insurance cover that the finance companies take out over the cars.) The interest rate would normally encompass a margin for the finance company that reflects credit risk and the finance companys expenses.

In this situation, the finance company finances the purchase of the car by the dealer, and the arrangement is a financing arrangement for the purpose of section 974-130.

By allowing the dealer to take possession of the car, which it can deal with but which the finance company has financed, the finance company provides the dealer with a financial benefit equal in value to the manufacturers price. As a result, the dealer has an effectively non-contingent obligation to pay the finance company an amount that will be at least equal to the amount that it received when the arrangement was entered into. Hence, a bailment floor plan with these features is a debt interest.

Example 2.35: Hire purchase transaction

Under a hire purchase transaction, a financier owns an item of property which it hires out to a customer. The customer pays hire fees and has an option to purchase the property, which it essentially exercises by paying the agreed fees. That is, the transaction is structured on the basis that all hire payments are to be made, whereupon title to the property passes to the customer.

The fees are calculated to pay the financier the cost of the property plus a return on the financiers investment. By entering into the hire purchase transaction, the customer essentially raises the finance necessary to acquire the property. The arrangement is a financing arrangement.

As a result of entering into the hire purchase transaction, the customer receives a financial benefit equal to the value of the funds required to acquire the item of property. This is because the contemplation of the transaction is that the property will pass to the customer, the funds for the purchase of which the financier, rather than the customer, has provided.

Under the arrangement, the customer has an effectively non-contingent obligation to pay hire fees that will at least equal the value of the property. Accordingly, a hire purchase contract of this nature is a debt interest.

Example 2.36: Repurchase agreements

Two different types of repurchase agreements (repos) can be distinguished: cash repos and securities repos.

Cash repos involve a finance provider buying securities from a finance obtainer and, as part of a packaged arrangement, agreeing to sell them back at a price greater than the purchase price. The difference between the buy and sell price is the product of the funds provided under the initial purchase contract, the time between that contract and the sale back contract and prevailing interest rates.

Cash repos enable the finance obtainer to raise finance (with securities used as collateral). They are financing arrangements that give rise to a debt interest, as the finance obtainer comes under an effectively non-contingent obligation to provide an amount at least equal to what it obtained.

Cash repos and arrangements that are economically equivalent include those referred to as reciprocal purchase agreements and sell-buyback arrangements.

Securities repos (also referred to as securities loan arrangements) involve an owner (the securities lender) of securities transferring title to another party (the securities borrower). In consideration of that, the securities borrower agrees to transfer either those or equivalent securities to the securities lender at a future date. Further, the borrower agrees to pay a fee that is based on the value of the securities and the time that the borrower has the securities, but not on interest rates. Although the securities borrower in substance borrows securities, generally it cannot be said to have raised finance, even if the arrangement does not fall within section 26BC of the ITAA 1936. If it does fall within that provision, paragraph 974-130(4)(b) specifically excludes it from being treated as a financing arrangement.

Some examples of interests that are not debt

2.209 Examples 2.37 to 2.39 provide a (non-exhaustive) selection of schemes that do not constitute debt. Again, the conclusion as to whether or not each one is debt depends on the terms and substance of the scheme rather than how it is described.

Example 2.37: Statutory obligations

A company derives taxable income and incurs a liability to pay income tax. Although the company has an effectively non-contingent obligation to provide a financial benefit (i.e. to pay an amount of money), there is no relevant scheme under which the company has received a financial benefit and thereby incurred the obligation. Therefore, there is no debt interest.

Example 2.38: Trade finance

A company buys supplies on terms allowing payment within 6 weeks. It pays for the supplies on time.

This arrangement is not debt because it is covered by the exception in subsection 974-25(2) of the ITAA 1997.

Example 2.39: Options

A company writes an at the money call option over an asset it holds which gives the purchaser of the option the right, but not the obligation, to acquire the asset in 3 months for a fixed price (which, because the option is at the money , is the same as the current market value of the asset). After the end of the 3 month period, the option holder exercises the right to purchase the asset.

This arrangement is not debt. At the time the arrangement was entered into, the company did not have an effectively non-contingent obligation to provide a financial benefit (i.e. deliver the asset). Rather, it had a contingent obligation because it only had to deliver the asset if the option holder exercised the option.

Application and transitional provisions

2.210 Subject to the concession explained in paragraph 2.211 the changes explained in this chapter apply from 1 July 2001, irrespective of when the relevant interest was issued. For example, the frankability and deductibility of payments on a hybrid instrument issued before 1 July 2001 will be subject to the current law until that date, from when it will be subject to the rules explained in this chapter. [Schedule 1, subitem 118(2)]

2.211 However, a company that, before the release of the exposure draft of this bill (on 21 February 2001), has issued a debt or equity interest may lodge a written election with the Commissioner for the current law to continue to operate in relation to that interest until 1 July 2004. The election must be lodged within 28 days after the day on which the Act containing the amendments receives Royal Assent or within such further time as the Commissioner allows. The Commissioner may only allow further time where the Commissioner is satisfied that the issuer did not have sufficient opportunity to make the election. [Schedule 1, subitems 118(10) and (11)]

2.212 If an election is made, the amendments described in this explanatory memorandum are to be disregarded when applying the law to such interests. This optional transitional rule provides for continuity in private sector decision-making and allows issuers sufficient time to redeem issued instruments in an orderly manner. [Schedule 1, subitem 118(6)]

2.213 The election needs to be in writing and is irrevocable. It must provide the specified information.

2.214 To avoid streaming, an election must cover all interests issued by the company which are substantially identical. [Schedule 1, subitem 118(10)]