House of Representatives

New Business Tax System (Taxation of Financial Arrangements) Bill (No. 1) 2003

Explanatory Memorandum

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

Chapter 1 - Removal of the taxing point on conversion or exchange of certain traditional securities

Outline of chapter

1.1 This chapter explains how the proposed amendments to remove the taxing point on conversion or exchange of traditional securities into ordinary shares will apply. It also explains the consequential amendments required to ensure the gain or loss on ultimate disposal of the ordinary shares is correctly calculated.

Context of reform

1.2 In the absence of these proposed amendments there would, under specific provisions of the income tax law, generally be a taxing point upon the conversion or exchange of a traditional security into ordinary shares. In broad terms, the cost of the traditional security at that time would be compared with the value of the cash or property received on conversion to determine if an amount is to be included in assessable income or allowed as a deduction.

1.3 The removal of the taxing point on the conversion or exchange of traditional securities into ordinary shares will prevent potential cash flow difficulties arising where the holder does not have the cash from the conversion or exchange to pay the tax on the conversion or exchange gains. Removing this taxing point and the associated potential cash flow consequences removes an impediment to the issue of such instruments, which typically have lower initial servicing costs than would otherwise be the case due to the conversion or exchange feature. Compared to the old law, this legislation will effectively defer the taxing point until the disposal of the ordinary shares acquired on conversion or exchange of a traditional security. This measure will implement Recommendation 9.7 (b)(i) of A Tax System Redesigned.

Summary of new law

1.4 The proposed amendments will:

·
remove the taxing point, under sections 26BB and 70B of the ITAA 1936, in respect of the conversion or exchange (into ordinary shares) of traditional securities issued after 7.30 pm, legal time in the Australian Capital Territory, on 14 May 2002; and
·
modify the cost base and reduced cost base of shares acquired on the exchange of traditional securities.

Comparison of key features of new law and current law
New law Current law
Sections 26BB and 70B of the ITAA 1936 will not apply when a traditional security converts or exchanges into ordinary shares. A taxing point arises under sections 26BB and 70B of the ITAA 1936 when a traditional security is disposed of or redeemed. Any gain is included in assessable income and any loss is allowed as a deduction.
As no amount is included in assessable income on disposal or redemption, there is no need to prevent double taxation. Accordingly, the cost base of the ordinary shares will not be 'stepped-up'. To prevent double taxation, the cost base of the ordinary shares acquired on disposal or redemption of a traditional security is increased by the amount included in assessable income. Any subsequent capital gain from the disposal of these ordinary shares takes into account this increased cost base.
A deduction will not be allowable for a loss when a traditional security converts or exchanges into ordinary shares. A deduction is allowable for a loss on the disposal or redemption of a traditional security.

Detailed explanation of new law

1.5 The following explanation of the new law will be divided into 2 sections:

·
the first section deals with the amendments - to sections 26BB and 70B, of the ITAA 1936 - that remove the taxing point on conversion or exchange of a traditional security into ordinary shares; and
·
the second section explains the modifications to the cost base and reduced cost base of ordinary shares acquired on the exchange of an exchangeable interest.

Overview of current legislation

1.6 Sections 26BB and 70B of the ITAA 1936 are complementary provisions that deal with gains and losses on the disposal of traditional securities acquired after 10 May 1989. They require gains to be included in assessable income (section 26BB), and treat losses as allowable deductions (section 70B).

1.7 Broadly, by subsection 26BB(2) the amount of any gain on the disposal or redemption of a traditional security is included in the assessable income of the holder of the traditional security at the time of disposal or redemption. Subsection 70B(2), subject to exceptions, essentially provides that the amount of any loss on the disposal or redemption of a traditional security is allowable as a deduction to the holder of the traditional security at the time of the disposal or redemption.

1.8 Where section 26BB applies in respect of a conversion or exchange gain the first element of the cost base of the ordinary shares acquired on conversion or exchange will include the gain. The 'stepped-up' cost base of the ordinary shares means that only those gains arising subsequent to acquisition of the ordinary shares are subject to tax in accordance with the CGT provisions.

Proposed amendments to sections 26BB and 70B of the ITAA 1936

1.9 The proposed amendments to remove the taxing point on conversion or exchange will apply in respect of:

·
traditional securities that will or may convert into ordinary shares of the issuing company or a connected entity of the issuing company [Schedule 1, item 2, subsection 26BB(4) and item 3, subsection 70B(2B)]; and
·
traditional securities that will or may exchange into ordinary shares of a company other than the issuing company or a company that is a connected entity of the issuing company [Schedule 1, item 2, subsection 26BB(5) and item 3, subsection 70B(2C)].

1.10 The amendments only apply to those traditional securities that convert into ordinary shares and those traditional securities that exchange into ordinary shares. The amendments will not apply to those traditional securities that convert or exchange into interests other than ordinary shares.

1.11 The benefit of convertible instruments (broadly, those that may or will convert into shares in the issuer) and exchangeable instruments (broadly, those that may or will convert into shares in a company other than the issuer) to issuers has traditionally been the ability to raise relatively cheap debt-like capital that will or may add to, or replace, ordinary share capital. The issuer uses the embedded call option over the ordinary shares to substantially reduce the servicing costs during the debt phase of the security. The taxing point on conversion or exchange was a factor inhibiting the ability of issuers to issue such securities. It is for this reason that the amendments are limited to traditional securities that convert or exchange into ordinary shares.

1.12 Where sections 26BB and 70B no longer apply to the conversion or exchange into ordinary shares, and any gain or loss on ultimate disposal of the shares is subject to the CGT provisions, it will not be necessary to treat the pre-conversion or pre-exchange period as on revenue account. In this situation, the amendments will not only defer the taxing point in this situation, but will also allow capital treatment for the period before, as well as after, conversion or exchange.

1.13 It should be noted that, in accordance with paragraph 23(b) of the Acts Interpretation Act 1901, the term 'shares' includes a single share. The term 'connected entity' has the same meaning as in subsection 995-1(1) of the ITAA 1997. [Schedule 1, item 1, subsection 26BB(1)]

Disposal or redemption of a traditional security

1.14 The amendments are to apply to certain disposals and redemptions of traditional securities. In relation to exchangeable interests, the amendments are limited to disposals to the issuer of the traditional security or a connected entity of the issuer. In relation to convertible (and converting) instruments, disposal is limited to conversion into ordinary shares of the issuer of the traditional security or a connected entity of the issuer. The amendments do not apply to disposal of traditional securities on the secondary market or to a disposal of an interest to the issuer or connected entity of the issuer where there has been no conversion or exchange. There is no need for a similar limitation in respect of the term 'redemption' as only the issuer may redeem securities. [Schedule 1, items 2 and 3, subsections 26BB(4), 26BB(5), 70B(2B) and 70B(2C)]

What are traditional securities?

1.15 Broadly, a traditional security, as defined in subsection 26BB(1), is a security that is not issued at a deep discount, does not bear a significant deferred interest element and is not capital indexed. A traditional security may be, for example, a bond, a debenture, a deposit with a financial institution or a secured or unsecured loan.

To what traditional securities that convert will the measures apply?

1.16 The amendments in proposed subsections 26BB(4) and 70B(2B) will apply in respect of those traditional securities that mandatorily convert into ordinary shares (a type of 'converting instrument') and traditional securities that may convert into ordinary shares (a type of 'convertible interest'). [Schedule 1, items 2 and 3, subsections 26BB(4) and 70B(2B)]

What are exchangeable interests?

1.17 An exchangeable interest is an interest that is a traditional security that is issued on the basis that it will or may exchange into shares in a company that is neither the issuer of the exchangeable interest nor a connected entity of the issuer. At exchange, the exchangeable interest is redeemed by the issuer or disposed of by the holder to the issuer or a connected entity of the issuer. [Schedule 1, item 15, section 130-100]

How amendments will apply to convertible interests that fall within the measures

1.18 No gain will be included in assessable income under section 26BB and no deduction for loss will be allowed under section 70B from the conversion of a traditional security that converts into ordinary shares of the issuer. [Schedule 1, items 2 and 3, subsections 26BB(4) and 70B(2B)]

How amendments will apply to exchangeable interests that fall within the measures

1.19 No gain will be included in assessable income under section 26BB and no deduction for loss will be allowed under section 70B from the exchange of a traditional security that exchanges into ordinary shares of a company other than the issuer or a connected entity of the issuing company. [Schedule 1, items 2 and 3, subsections 26BB(5) and 70B(2C)]

Amendments to CGT provisions

Any capital gain or loss on disposal or redemption is to be disregarded

1.20 Any capital gain or loss from the disposal of an exchangeable interest to the issuer of the interest or to a connected entity of the issuer, or from its redemption, will be disregarded. [Schedule 1, item 15, subsection 130-105(4)]

Acquisition of ordinary shares on exchange

1.21 The holder of an exchangeable interest that is exchanged into shares of a company acquires the shares when the exchange of the exchangeable interest happens. [Schedule 1, item 4, section 109-55]

1.22 For the purpose of the CGT discount in Subdivision 115-A of the ITAA 1997, the period of ownership of a share acquired on exchange commences when the share is acquired on exchange, not when the exchangeable interest is purchased.

Example 1.1: CGT discount and shares acquired on exchange An individual purchases an exchangeable interest on 1 July 2002. On 1 October 2002 the individual exchanges the interest for ordinary shares in ABC Company (ABC). Ten months later the individual disposes of the ABC shares. As the period of share ownership is 10 months rather than 12 months or more, the CGT discount will not apply to the disposal of the ABC shares.

Cost base modification rule for shares acquired on disposal or redemption of an exchangeable interest

1.23 For exchangeable interests that fall within Subdivision 130-E of the ITAA 1997, the first element of the cost base of shares acquired on the disposal or redemption of an exchangeable interest will be modified so that it is the total of:

·
the cost base of the exchangeable interest at the time of disposal or redemption;
·
an amount (if any) paid for the exchange; and
·
an amount (if any) by which a capital gain from the exchange of the exchangeable interest has been reduced under section 118-20.

[Schedule 1, item 15, section 130-105]

1.24 A payment for the exchange of an exchangeable interest can include giving property. [Schedule 1, item 15, subsection 130-105(3)]

1.25 The cost base of the exchangeable interest at the time of exchange does not take into account the market value of the exchangeable interest at the time of exchange. Rather, by looking at the cost base at the time of disposal or redemption, it takes into account the amount paid for the exchangeable interest at the time of its acquisition.

1.26 For exchangeable interests that fall within the proposed Subdivision 130-E, the first element of the cost base or reduced cost base (acquisition cost) will be increased by amounts that have reduced a capital gain the taxpayer has made from exchange. This is so even though the capital gain is disregarded under this Subdivision. This is achieved by providing a direct link to section 118-20 of the ITAA 1997. Section 118-20 avoids double taxation, as a capital gain made from a CGT event is reduced under this section to take account of any other provisions that include an amount in assessable or exempt income.

1.27 Subdivision 130-E does not require a capital gain to be realised on exchange of an exchangeable interest. Rather, it defers the realisation of a capital gain to the final disposal of the share. As a result, section 118-20 is unable to reach back to the exchangeable interest before it was exchanged into a share. This is because section 118-20, in working out the capital gain to be realised on the sale of the share, only takes account of any other provision that includes an amount in assessable or exempt income because of the CGT event happening to the share, and not the exchangeable interest. Thus, a specific link is needed within Subdivision 130-E to take into account amounts included in assessable income or exempt income because of a CGT event happening to an exchangeable interest. This avoids double tax on that final disposal of a share. [Schedule 1, item 15, subsection 130-105(2)]

1.28 For exchangeable interests that fall within the amendments to sections 26BB and 70B, the first element of the cost base of ordinary shares acquired by conversion or exchange will not be increased (or 'stepped-up') to reflect its then market value. This is not necessary where an amount will not be included in assessable income under section 26BB. However, if an amount is so included (e.g. because there is an exchange into preference shares), the cost base will be increased where a gain is taxed on conversion or exchange. [Schedule 1, item 15, paragraph (c) in the table in subsection 130-105(1) and item 15, subsection 130-105(2)]

Example 1.2: Cost base of a share acquired on exchange of an exchangeable interest where no amount is included in assessable income under section 26BB A taxpayer in year 1 acquires on issue an exchangeable note for $100 which has a face value of $100. The interest is acquired on 1 July 2002. The exchangeable interest has a term of 5 years, subject to the holder's annual option to exchange it into one ordinary share. In each of the years the exchangeable interest is not exchanged the taxpayer will receive $5 interest income.The exchangeable note is a traditional security and is an exchangeable interest under section 130-100 of the ITAA 1997.At the beginning of year 3, the taxpayer exchanges the interest for a share with a market value of $110.Due to the application of proposed subsection 26BB(5) of the ITAA 1936, the gain of $10 is not included in the taxpayer's assessable income at the time of exchange. There will be no need to avoid double taxation occurring on the eventual sale of the share because there is no taxing point in relation to disposal of the share prior to that time. Accordingly, when working out the first element of the cost base of the share there is no need to increase the cost base by an amount that has reduced a capital gain made on the exchangeable interest.The exchange of the interest leads to the taxpayer making a capital gain (even though the capital gain is disregarded).Subsection 118-20(1) of the ITAA 1997 does not reduce that capital gain because there is no section 26BB amount.As a result, the first element of the cost base of the share would be $100. This is the $100 purchase price of the exchangeable interest (assuming this is the cost base of the interest at the time of conversion).The $5 interest the taxpayer receives annually on the exchangeable interest does not form part of the cost base of the share. This is because section 118-20 does not reduce the capital gain by those amounts.If the taxpayer then sells the share for $120, the taxpayer will have a capital gain of $20, being the difference between the cost base (assuming it is still $100) and the capital proceeds of $120.

1.29 Similar cost base modification rules apply to convertible interests. [Schedule 2, item 7, subsection 130-60(1)]

Amounts deducted

1.30 By referencing the first element of the cost base and reduced cost base of the share to the cost base of the exchangeable interest at the time of its disposal or redemption, an amount in respect of the cost base that is deductible to the taxpayer would reduce that cost base before it is incorporated into the first element of the cost base of the share. Division 110 of the ITAA 1997 provides rules for working out an asset's cost base and reduced cost base. [Schedule 1, item 15, subsection 130-105(1)]

Application and transitional provisions

1.31 There is no taxing point, at conversion or exchange, under these proposed provisions in respect of a traditional security that is a convertible or exchangeable interest respectively issued after 7.30 pm, legal time in the Australian Capital Territory, on 14 May 2002. A traditional security that is a convertible instrument, a converting instrument or an exchangeable interest that was issued at or before that time will be subject to the then existing law. [Schedule 1, item 17]

1.32 The amendments to CGT measures in respect of a share acquired on the exchange of an exchangeable interest will apply to exchangeable interests issued on or after 1 July 2001. [Schedule 1, items 4 to 17]

1.33 The amendment to section 130-40 will apply to the exercise of a right on or after 1 July 2001 [Schedule 3, item 2] and the amendment to section 130-60 will apply to the conversion of a convertible interest on or after 1 July 2001 [Schedule 2, item 9].

Technical corrections

1.34 Technical corrections will be made to replace the term 'convertible note' with the term 'convertible interest' to ensure consistency throughout the CGT measures. [Schedule 1, item 14, new subsection 130-1; Schedule 2, item 1, paragraph 122-25(4)(a), item 2, paragraph 122-25(4)(b), item 3, paragraph 122-135(4)(a), item 4, paragraph 122-135(4)(b), item 5, paragraph 126-50(3)(a), item 6, paragraph 126-50(3)(b), item 7, subsection 130-60(1) and item 8, subsection 130-60(1B)]

1.35 These technical corrections will apply to the conversion of a convertible interest on or after 1 July 2001. [Schedule 2, item 9]

1.36 Sections 130-40 and 130-60 will be amended to clarify that the first element of the cost base for shares or units in a unit trust acquired on conversion of a convertible interest includes any amount paid to convert a convertible interest and for shares, units or options acquired on exercising a right includes any amount paid to exercise the right [Schedule 2, item 7, subsection 130-60(1); Schedule 3, item 1, subsection 130-40(6)]. Another amendment will ensure that a payment to convert a convertible interest can include giving property [Schedule 2, item 8, subsection 130-60(1B)].

1.37 The amendment to section 130-40 will apply to the exercise of a right on or after 1 July 2001 [Schedule 3, item 2] and the amendment to section 130-60 will apply to the conversion of a convertible interest on or after 1 July 2001 [Schedule 2, item 9].

Regulation impact statement

Policy objective

1.38 The policy objective of the proposed amendments is to prevent potential cash flow difficulties arising where the holder of traditional securities that convert or exchange into ordinary shares does not have the cash from the conversion or exchange to pay the tax on conversion or exchange gains. This is designed to remove an impediment to the issue of such instruments.

Implementation options

1.39 The measure to remove the taxing point on conversion or exchange of traditional securities, issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002, into ordinary shares will implement Recommendation 9.7 (b)(i) of A Tax System Redesigned. The recommendations of that report were the subject of extensive consultation. A Tax System Redesigned itself reflected earlier consultation on A Platform for Consultation.

1.40 A Platform for Consultation discussed the options as to when a taxing point should occur in respect of a convertible note. The issue was whether there should be a taxing point on conversion when the risk profile changed from debt to equity or no taxing point until the ultimate disposal of the share. As indicated, A Tax System Redesigned recommended the latter approach.

1.41 The proposed legislation will remove the taxing point on conversion or exchange of certain traditional securities that are issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002. This means that an investor who acquires an ordinary share through the conversion or exchange of a traditional security issued after that time will not be subject to tax until that ordinary share is ultimately sold. Furthermore, where the gain or loss on disposal of a traditional security is of a capital nature, the investor will be able to qualify for capital gains treatment for the period before, and after, conversion or exchange. The existing legislation will continue to apply to traditional securities issued before 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002.

Assessment of impacts

1.42 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered, both by the Government and the Review of Business Taxation and through extensive consultation with the business sector. Submissions received during consultation on the exposure draft of the New Business Tax System (Taxation of Financial Arrangements) Bill 2002 did not indicate significant concerns about compliance issues.

Impact group identification

1.43 Companies as the predominant issuers of traditional securities that are convertible interests or exchangeable interests will need to familiarise themselves with the changed tax treatment of traditional securities that convert or exchange into ordinary shares.

1.44 Superannuation funds, large/medium business, small business, and individuals will be impacted to the extent that they invest in these traditional securities. However, issuers will generally advise investors of the tax treatment of the instruments.

Analysis of costs / benefits

Compliance costs

1.45 The issuers of these traditional securities will be potentially any company. However, many issuers will be small and medium sized companies, new ventures and expanding companies that have a sophisticated understanding of the tax law and have ready access to high level tax advice so that they would quickly and easily understand the changes to the law. The benefits of the legislative change are likely to be disseminated widely by tax advisers.

1.46 The proposed amendments will predominantly impact on the holders of traditional securities that are convertible interests or exchangeable interests issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002. The removal of the taxing point on conversion or exchange means that the holder will no longer have to make a calculation of the gain or loss to be included in assessable income or allowed as a deduction for that point in time. The removal of the taxing point will also mitigate any potential cash flow difficulties that may otherwise have arisen when a gain arose and the holder did not have the cash from the conversion or exchange to pay the tax.

1.47 To the extent that the tax treatment of a particular security is changed by the legislation, issuers will be required to tell their holders of that change in accordance with Australian Stock Exchange disclosure rules. However, it is expected that this will be a transitional requirement, because the measure does not affect traditional securities issued before its date of effect.

Administration costs

1.48 The administrative impact on the ATO will arise from enquiries by holders as to the correct tax treatment of their traditional securities. The ATO will be taking steps to change its information products for individual taxpayers to reflect the new measure, as well as to educate tax agents. Education needs of issuers will be low as most will be assisted by sophisticated advisers with ready access to tax advice.

1.49 To the extent that the tax treatment of particular securities is changed by the legislation, the ATO will also have a responsibility to ensure that taxpayers are informed of changes affecting them.

Government revenue

1.50 This measure is estimated to have no impact on the revenue over the forward estimates period. This is because convertible/exchangeable interests typically have a minimum term of 4 years and the proposed amendments apply only to traditional securities that are convertible interests or exchangeable interests issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002. After this period, the measure may have a negative impact on revenue due to more concessional taxation of gains on conversion or exchange under the capital gains tax provisions and due to the deferral of the taxing point.

1.51 However, the impact on the revenue will depend upon the extent of gains or losses made on conversion or exchange. On average it can be expected that the value of the investments will appreciate over time.

1.52 If gains were made there would be a negative impact on revenue for 2 reasons. First, capital gains are taxed concessionally relative to income tax. In particular, for individuals subject to CGT, half of the gain is included in assessable income while for superannuation funds a capital gain is taxed at the rate of 10%. This cost arises because under current law gains/losses prior to conversion/exchange are subject to income tax and gains/losses post conversion/exchange are subject to CGT, whereas under the proposed reform gains/losses would be subject to CGT over the whole period. Second, tax is deferred until the ultimate sale of the shares (possibly many years in the future), which imposes a cost on the Commonwealth due to the time value of money.

1.53 Conversely, if losses are made on conversion or exchange there would be a positive affect on revenue for 2 reasons. First, as capital gains are taxed concessionally relative to income tax a capital loss will be of less value relative to a loss on income. Second, the realisation of the loss will be deferred until the ultimate sale of the shares.

Economic benefits

1.54 This proposed measure will benefit both holders and issuers. For holders it will remove potential cash flow disadvantages and will effectively defer the taxing point until the disposal of the ordinary shares acquired on conversion or exchange. The benefits to holders should create a greater demand for these traditional securities.

1.55 This increased demand will allow issuers (including start-up entities) to raise more capital at initially cheaper rates. These traditional securities provide an initially cheaper form of capital than ordinary debt because the return paid during the debt phase is relatively lower because the holder effectively has the benefit of an option to convert or exchange the traditional security into ordinary shares.

1.56 Australian issuers will be more competitive as they will be able to issue such traditional securities on the same basis as foreign issuers from countries that also defer the taxing point.

Consultation

1.57 The consultation process began with the release of A New Tax System in August 1998. The Government established the Review of Business Taxation in that month. Since then, the Review of Business Taxation has published 4 documents about business tax reform: in particular A Platform for Consultation and A Tax System Redesigned which canvassed options, discussed issues and sought public input.

1.58 Throughout that period, the Review of Business Taxation held numerous public seminars and focus group meetings with key stakeholders in the tax system. It received and analysed 376 submissions from the public about reform options. Further details are contained in paragraphs 11 to 16 in the Overview of A Tax System Redesigned.

1.59 In analysing options, the published documents frequently referred to, and were guided by, views expressed during the consultation process.

1.60 The measure removing the taxing point on conversion on exchange of traditional securities into ordinary shares was included in the exposure draft of the New Business Tax System (Taxation of Financial Arrangements) 2002 Bill, on which there was consultation followed by submissions from interested parties.

Conclusion and recommended option

1.61 This proposal will address potential cash flow disadvantages by removing the taxing point on conversion or exchange for those traditional securities issued after 7.30 pm, by legal time in the Australian Capital Territory, on 14 May 2002, that will or may convert or exchange into ordinary shares.


View full documentView full documentBack to top