House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 2 - Amendments to the capital protected borrowings provisions

Outline of chapter

2.1 Schedule 2 to this Bill amends Division 247 of the Income Tax Assessment Act 1997 (ITAA 1997) and the Income Tax (Transitional Provisions) Act 1997 (IT(TP) Act 1997) to adjust the benchmark interest rate used to determine, for income tax purposes, the cost of capital protection on a capital protected borrowing.

Context of amendments

2.2 A typical capital protected borrowing product is an arrangement that involves a limited recourse borrowing to fund the purchase of securities. Under the arrangement, the borrower is able to transfer the securities to the lender, in full satisfaction of the obligation to repay the loan principal, if the value of the securities falls below the amount borrowed. This ensures that the borrower's capital is protected against a fall in value of the securities.

2.3 Division 247 of the ITAA 1997 ensures that the part of the expense of a capital protected borrowing attributable to the cost of capital protection is:

•

for income tax purposes, treated as separate to and distinct from the amount attributable to interest payable on a borrowing without capital protection; and

•

not deductible where this cost is capital in nature.

2.4 Division 247 provides a basis for apportionment - between interest on a borrowing without capital protection and the cost of capital protection - that is relatively simple to use and easy to access, to cover a wide range of capital protected borrowings. The Division uses two methodologies to determine the cost of capital protection for income tax purposes, depending on when the capital protected borrowing arrangement is entered into:

•

an interim methodology; and

•

an ongoing (pre 2008-09 Budget) methodology.

2.5 Under the interim methodology, the cost of capital protection is the higher of the amount calculated under the Indicator Method and the Percentage Method. The Indicator Method is the total amount (for capital protection and interest) in excess of an amount worked out by applying the relevant indicator lending rate, namely the Reserve Bank of Australia's (RBA's) Indicator Lending Rate for Personal Unsecured Loans - Variable Rate, to the borrowing under the capital protected borrowing. The Percentage Method uses the total amount times a set percentage, depending on the term of the capital protected borrowing. The interim methodology applies to capital protected borrowings entered into or extended at or after 9.30 am, by legal time in the Australian Capital Territory, on 16 April 2003 and before 1 July 2007.

2.6 Under the ongoing (pre 2008-09 Budget) methodology, the cost of capital protection is the amount in excess of the amount worked out by applying the applicable benchmark interest rate (the RBA's Indicator Lending Rate for Personal Unsecured Loans - Variable Rate) to the borrowing under the capital protected borrowing. This methodology applies to capital protected borrowings entered into or extended on or after 1 July 2007 but no later than 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 2008 (and not extended or changed after that time).

2.7 Both methodologies use a benchmark interest rate to apportion the expense in a capital protected borrowing between interest on a borrowing that does not embed the cost of capital protection and the cost of capital protection.

2.8 The indicator interest rates are the indicator lending rates published monthly by the RBA in the RBA Statistical Bulletin Table F5. They may be accessed via the RBA's website http://www.rba.gov.au.

Summary of new law

2.9 Schedule 2 amends Division 247 of the ITAA 1997 and Division 247 of the IT(TP) Act 1997 so that the applicable RBA's Indicator Lending Rate(s) for Standard Variable Housing Loans plus 100 basis points is used as the interest rate to calculate the amount attributable to the cost of capital protection on a capital protected borrowing entered into, extended or amended after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 2008 (the 2008 Budget time). The cost of capital protection for capital protected borrowings entered into, extended, or amended after the 2008 Budget time is the amount in excess of the amount worked out by applying the applicable RBA's Indicator Lending Rate(s) for Standard Variable Housing Loans plus 100 basis points to the borrowing under the capital protected borrowing (this is referred to as the post 2008-09 methodology).

2.10 The RBA's Indicator Lending Rate for Standard Variable Housing Loans plus 100 basis points is considered to more appropriately reflect the credit risk borne by lenders in capital protected borrowings.

2.11 For the purpose of determining the applicable apportionment methodology, this Bill provides for a transitional arrangement that:

•

allows capital protected borrowings entered into or extended on or after 1 July 2007 and at or before the 2008 Budget time , and still in existence at the 2008 Budget time, to continue to use the applicable RBA's Indicator Lending Rate(s) for Personal Unsecured Loans - Variable Rate, until 30 June 2013 or the end of the life of the arrangement (provided it is not extended or amended after the 2008 Budget time), whichever is earlier; and

•

allows capital protected borrowings entered into or extended before 1 July 2007 and still in existence at the 2008 Budget time , to continue to apply the interim methodology until 30 June 2013 or the end of the life of the arrangement (provided it is not extended or amended on or after 1 July 2007), whichever is earlier.

Comparison of key features of new law and current law

Detailed explanation of new law

'Adjusted loan rate'

2.12 Schedule 2 amends Division 247 of the ITAA 1997 so that the applicable RBA's Indicator Lending Rate(s) for Standard Variable Housing Loans plus 100 basis points (the adjusted loan rate ) is used to calculate the amount attributed to the cost of capital protection on a capital protected borrowing entered into, amended or extended after the 2008 Budget time. [ Schedule 2, items 1, 4, 7 and 12, section 247-20 of the ITAA 1997 and section 247-85 of the IT(TP) Act 1997 ]

2.13 The 'adjusted loan rate' achieves a better allocation of the cost of capital protection and the interest expense of a capital protected borrowing borrower as it better reflects both the credit risk (including credit risks for the cost of capital protection that is paid on a deferred basis) and the administration costs of the issuer of a capital protected borrowing.

2.14 The credit risk borne by the issuer of capital protected borrowings is considered to be more aligned with housing loans rather than personal unsecured loans. The addition of 100 basis points is to reflect the typically relatively small additional credit risk of the issuer for the cost of capital protection that is paid on a deferred basis.

How the 'adjusted loan rate' is used

2.15 The 'adjusted loan rate' is used to determine how much of the interest expense incurred by the borrower under a capital protected borrowing is attributable to the borrowing without the capital protection and therefore may qualify for deduction under general deductibility rules in the income tax law. The rest of the interest expense, that is, the amount in excess of that worked out by applying the 'adjusted loan rate' to the borrowing is taken to be reasonably attributable to the cost of protecting the capital and taken to be a put option premium. [ Schedule 2, item 7, subsections 247-20(4) , ( 5) and ( 5A) of the ITAA 1997 ]

Capital protected borrowing is at a fixed rate for all or part of the term

2.16 Where a capital protected borrowing is at a fixed rate for the full term of the capital protected borrowing, the applicable 'adjusted loan rate' is the RBA's Indicator Lending Rate for Standard Variable Housing Loans at the time of the first amount incurred by the borrower under the capital protected borrowing during the term of the capital protected borrowing, plus 100 basis points. [ Schedule 2, item 7, subsections 247-20(4) and ( 5) of the ITAA 1997 ]

2.17 Where a capital protected borrowing is at a fixed rate for part of the term of the capital protected borrowing and the fixed rate is applicable to the capital protected borrowing for all or part of the income year, the applicable 'adjusted loan rate' is the RBA's Indicator Lending Rate for Standard Variable Housing Loans at the time of the first amount incurred by the borrower under the capital protected borrowing during that part of the term of the capital protected borrowing (which may be before the start of the income year), plus 100 basis points.

Capital protected borrowing is at a variable rate for all or part of the term

2.18 Where a capital protected borrowing is at a variable rate for all or part of the term of the capital protected borrowing and a variable rate is applicable to the capital protected borrowing for all or part of the income year, the applicable 'adjusted loan rate' is the average of the RBA's Indicator Lending Rates for Standard Variable Housing Loans published during the parts of the income year when the capital protected borrowing is at a variable rate, plus 100 basis points. [ Schedule 2, item 7, subsections 247-20(5) and ( 5A) of the ITAA 1997 ]

Example 2.4: Capital protected borrowing entered into after 13 May 2008

David enters into a variable rate capital protected borrowing on 1 July 2008 under which he borrows $100,000 to buy shares. The capital protected borrowing has a term of one year, with no option to extend the loan. The applicable 'adjusted loan rate' for the capital protected borrowing for the 2008-09 income year is the average of the monthly RBA's Indicator Lending Rates for Standard Variable Housing Loans plus 100 basis points from 1 July 2008 to 30 June 2009. The 'adjusted loan rate' for the relevant period is 8.279 per cent.

As the capital protected borrowing is at a variable rate for the term of the capital protected borrowing, David applies the average 'adjusted loan rate' to determine the amount of interest expense attributable to capital protection.

Transitional provisions

Capital protected borrowings entered into or extended on or after 16 April 2003 and before 1 July 2007

2.19 Capital protected borrowings entered into or extended at or after 9.30 am on 16 April 2003 and before 1 July 2007 (the interim period) that have been subject to the interim methodology contained in the IT(TP) Act 1997 continue to be subject to the interim methodology until 30 June 2013 or the end of the life of the arrangement (provided it is not extended or amended on or after 1 July 2007), whichever is earlier. [ Schedule 2, item 12, sections 247-80 and 247-85 of the IT(TP) Act 1997 ]

2.20 Such capital protected borrowings still in existence on 1 July 2013 will become subject to the post 2008-09 Budget methodology using the applicable 'adjusted loan rate' rather than the interim methodology, from 1 July 2013. [ Schedule 2, item 12, section 247-80 of the IT(TP) Act 1997 ]

Capital protected borrowings entered into or extended on or after 1 July 2007 and at or before the 2008 Budget time

2.21 Capital protected borrowings entered into or extended on or after 1 July 2007 and at or before the 2008 Budget time continue to be subject to the ongoing (pre 2008-09 Budget) methodology applying the applicable RBA's Indicator Lending Rate(s) for Personal Unsecured Loans - Variable Rate to attribute the cost of capital protection, until 30 June 2013 or the end of the life of the arrangement (provided it is not extended or amended after the 2008 Budget time), whichever is earlier. [ Schedule 2, item 12, sections 247-75 to 247-85 of the IT(TP) Act 1997 ]

2.22 Such capital protected borrowings still in existence on 1 July 2013 will apply the applicable 'adjusted loan rate' to attribute the cost of capital protection rather than the RBA's Indicator Lending Rate for Personal Unsecured Loans - Variable Rate, from 1 July 2013. [ Schedule 2, item 12, section 247-80 of the IT(TP) Act 1997 ]

2.23 The applicable RBA's Indicator Lending Rate(s) for Personal Unsecured Loans - Variable Rate continues to apply to capital protected borrowings (or arrangements in respect of unlisted securities) entered into during the interim period that are extended after 1 July 2007 but at or before the 2008 Budget time (to the extent of such an extension).

2.24 However, if these capital protected borrowings are still in existence after 30 June 2013 the applicable 'adjusted loan rate' will apply after 30 June 2013. [ Schedule 2, item 12, section 247-80 of the IT(TP) Act 1997 ]

Example 2.5: Capital protected borrowings entered into on or after 1 July 2007 and at or before the 2008 Budget time, and in existence on 1 July 2013

Alissa enters into a capital protected borrowing on 1 July 2007. The capital protected borrowing has a term of eight years. The capital protected borrowing has not been amended or extended.

Alissa applies the applicable RBA's Indicator Lending Rate for Personal Unsecured Loans - Variable Rate to determine the amount of interest expense attributable to capital protection up to 30 June 2013. From 1 July 2013 to the end of the capital protected borrowing on 30 June 2015, the applicable 'adjusted loan rate' will be applied to attribute the cost of capital protection.

Capital protected borrowings entered into at or before the 2008 Budget time, but extended or amended after the 2008 Budget time

2.25 Capital protected borrowings entered into at or before the 2008 Budget time (either during the interim period or on or after 1 July 2007), but amended or extended after the 2008 Budget time are subject to the post 2008-09 Budget methodology applying the applicable 'adjusted loan rate' to attribute the cost of capital protection, from the time of the extension or amendment or the start of 1 July 2013, whichever is earlier. [ Schedule 2, item 12, section 247-85 of the IT(TP) Act 1997 ]

2.26 Where a capital protected borrowing is at a fixed rate when a post 2008 Budget time amendment or extension occurs, from the time the amendment or extension took effect or 1 July 2013 (whichever is earlier), use the monthly RBA's Indicator Lending Rate for Standard Variable Housing Loans published at the first time an amount incurred by the borrower under the capital protected borrowing while the capital protected borrowing is at that fixed rate, plus 100 basis points. [ Schedule 2, item 12, subsection 247-85(3) of the IT(TP) Act 1997 ]

2.27 Where a capital protected borrowing is at a variable rate when a post 2008 Budget time amendment or extension occurs, from the time the amendment or extension took effect or 1 July 2013 (whichever is earlier), use the average of the monthly RBA's indicator Lending Rates for Standard Variable Housing Loans (as published) during those parts of the income year when the capital protected borrowing is at a variable rate, plus 100 basis points. [ Schedule 2, item 12, subsection 247-85(4) of the IT(TP) Act 1997 ]

Example 2.6: Capital protected borrowings entered into on or after 1 July 2007 and at or before the 2008 Budget time, and extended after the 2008 Budget time

James entered into a capital protected borrowing on 1 August 2007. The capital protected borrowing has a term of one year, with an option to extend for another six months which may be exercised at any time during the term of the capital protected borrowing. James exercised the option to extend on 30 May 2008. The extension took effect on 1 August 2008.

James applies the applicable RBA's Indicator Interest Rate for Personal Unsecured Loans - Variable Rate to determine the amount of interest expense attributable to capital protection from 1 August 2007 to 30 June 2008 for the 2007-08 income year. For the 2008-09 income year, James applies the applicable RBA's Indicator Interest Rate for Personal Unsecured Loans - Variable Rate from 1 July 2008 to 31 July 2008 and the applicable 'adjusted loan rate' from 1 August 2008 to 30 January 2009.

If the capital protected borrowing is a fixed rate borrowing for the term of the borrowing, from 1 August 2008, the applicable 'adjusted loan rate' is the monthly RBA's Indicator Lending Rate for Standard Housing Loans as at August 2007 plus 100 basis points.

If the capital protected borrowing is a variable rate borrowing for the term of the borrowing, from 1 August 2008, the applicable 'adjusted loan rate' is the average of the monthly RBA's Indicator lending Rates for Standard Housing Loans from July 2008 to January 2009, plus 100 basis points.

2.28 The transitional arrangements discussed above are set out in broad terms in tabular form below.

Consequential amendments

2.29 Given that the amendments contained in this Schedule generally apply from the 2008 Budget time, a consequential amendment is inserted to provide a period of two years from the date this Bill receives Royal Assent for the Commissioner of Taxation to amend an assessment that is issued before the date of Royal Assent to give effect to the amendments contained in this Schedule. [ Schedule 2, subclause 4(1) ]

2.30 Changes to the benchmark interest rate to the RBA's Indicator Lending Rate for Standard Variable Housing Loans were originally announced on 13 May 2008. Implementation of the announced changes was delayed to address industry concerns that the announced rate did not appropriately reflect the credit risks borne by lenders in capital protected borrowings.

2.31 As a result of subsequent consultation with industry, the Government announced in the 2010-11 Budget that the benchmark rate would be revised upwards by 100 basis points to take into account the additional credit risk borne by lenders for the cost of capital protection that is paid on a deferred basis and that the transitional arrangements would be extended to 30 June 2013.

2.32 These amendments apply retrospectively to capital protected borrowing entered into, amended or extended after the 2008 Budget time, but they are beneficial to affected taxpayers compared to the benchmark interest rate announced on 13 May 2008.

2.33 Other consequential amendments are made to ensure appropriate referencing and asterisking. [ Schedule 2, items 2, 3, 5, 6 and 8, section 247-20 of the ITAA 1997 ; Schedule 2, items 9 to 11, Division 247 and section 247-5 of the IT(TP) Act 1997 ]