Explanatory Memorandum(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)
Chapter 6 - Limited recourse debt
Outline of chapter
6.1 Schedule 6 to this Bill amends Division 243 of the Income Tax Assessment Act 1997 (ITAA 1997) (the limited recourse debt provisions) to clarify that the definition of 'limited recourse debt' includes arrangements where, in substance or effect, the debtor is not fully at risk in relation to the debt.
6.2 Under such arrangements, the creditor's rights as against the debtor in the event of default in payment of the debt are, in substance or effect, limited wholly or predominantly to rights in relation to certain assets.
6.3 All references to legislative provisions in this chapter are references to the ITAA 1997 unless otherwise stated.
Context of amendments
6.4 The purpose of the limited recourse debt tax provisions is to recoup excess capital allowance deductions claimed with respect to capital expenditure where the taxpayer:
- has not been fully at risk in relation to the expenditure because it is financed by a limited recourse debt; and
- has not fully repaid the debt upon termination.
6.5 The provisions operate to reverse capital allowance deductions that, at the time the debt is terminated, are excessive having regard to the amount of the debt repaid.
6.6 Limited recourse debt refers to financing arrangements where the creditor's rights of recourse, are wholly or predominantly limited to rights in respect of specific assets. This is determined at the start of the arrangement (or when varied prior to termination).
6.7 A creditor's rights of recourse can be limited by contractual terms or by the overall effect of an arrangement, for example, where a special purpose entity debtor predominantly holds and operates the financed assets. In both situations, the debtor is not fully at risk with respect to the debt and therefore the capital expenditure which is financed by the debt.
6.8 The current definition of 'limited recourse debt' in section 243-20 is intended to include contractually limited recourse debt arrangements as well as debt arrangements where recourse is effectively limited through arrangements.
6.9 That is, Division 243 is intended to apply to a debt arrangement irrespective of whether the limited recourse element of the debt is achieved using an explicit contractual limitation or because of the overall effect of the arrangement.
6.10 However, the High Court, in Commissioner of Taxation v BHP Billiton Limited  HCA 17, held that the current definition only includes debt arrangements where the recourse is contractually limited or is capable of being legally limited.
6.11 As such, amendments to the law are needed to ensure that the limited recourse debt tax provisions operate as originally intended.
Summary of new law
6.12 The definition of 'limited recourse debt' is clarified to include a debt arrangement where it is reasonable to conclude that the debtor has not been fully at risk with respect to the debt because the creditor's recourse is effectively limited to the financed property or property provided to secure the debt.
Comparison of key features of new law and current law
|New law||Current law|
|A debt is a limited recourse debt if it is reasonable to conclude that the creditor's rights of recourse are in substance or effect limited wholly or predominantly to rights in relation to the financed property or property provided to secure the debt (the debt property).||A debt is a limited recourse debt if the creditor's rights of recourse are contractually limited to rights in relation to the debt property.
A debt is also a limited recourse debt if there are no contractual terms to that effect, but it is reasonable to conclude that the creditor's recourse is capable of being legally limited to rights in relation to the debt property.
Detailed explanation of new law
6.13 To ensure that the limited recourse debt tax provisions achieve their original policy intent, this Schedule clarifies the definition of 'limited recourse debt' so that it includes debt arrangements where it is reasonable to conclude that the creditor's rights against the debtor in the event of default are, in substance or effect, limited wholly or predominantly to the rights in relation to the financed property or property provided to secure the debt (being the same rights as those listed in current paragraph 243-20(1)(a)). [Schedule 6, item 1, subsection 243-20(2)]
6.14 The amendments ensure that the limited recourse debt tax provisions are not circumvented through the use of other arrangements which have the same commercial effect as contractually limited recourse debt arrangements.
6.15 Consistent with the current law, the question of whether the creditor's rights of recourse are limited in substance or effect is determined at the start of the arrangement (as varied prior to the termination of the debt).
6.16 In working out whether it is reasonable to conclude that the creditor's rights against the debtor in the event of default in payment of the debt or of interest are limited in substance or effect, regard must be given to:
- the debtor's assets (other than assets that are indemnities or guarantees provided in relation to the debt);
- any arrangement to which the debtor is a party; and
- whether the debtor and the creditor are dealing at arm's length in relation to the debt.
[Schedule 6, items 2 and 3, subsections 243-20(3) and (3A)]
Example 6.18 Company C is a specific purpose business vehicle owned by an offshore company. Company C has $60 million in cash and no other assets.In year 1, Company C acquires an asset for $320 million and finances the acquisition of the asset using $60 million of its own funds and $260 million of debt borrowed from Bank B. Under the loan agreement, there is no contractual limitation on Bank B's rights to recover the debt from Company C. As such, Bank B has recourse to the asset and revenue of Company C in the event of default.The debt is a limited recourse debt for the purposes of Division 243 as Bank B's rights against Company C are effectively limited wholly or predominantly to the assets of Company C, which are predominantly financed by the debt, notwithstanding there is no contractual limitation on Bank B's rights of recourse.In this case, Company C is at risk with respect to the $60 million of its own funds and not fully at risk with respect to the $260 million debt borrowed from Bank B.For tax purposes, assume that the asset depreciates on a straight line basis over a 10 year period.In year 5, Company C defaults on the loan. At the time of default, the market value of the asset is nil and no interest payments or principal repayments have been made on the loan by Company C.Company C has claimed capital allowance deductions of $128 million (that is, ($320 million/10) ×4) with respect to the asset, but only incurred expenditure of $60 million for the asset.As such, in Year 5, an adjustment of the capital allowance deductions claimed is made and $68 million (that is, $128 million reduced by $60 million) is added to Company C's assessable income for the year.In year 6 and future years (to year 10) Company C's remaining capital allowance deductions are adjusted such that no further amounts are allowable except where additional payments are made.Overall, this ensures that Company C's capital allowance deductions are limited to the company's actual expenditure of $60 million.
Example 6.19 Head Co is the head company of a tax consolidated group that includes a special purpose business vehicle (SPE Co) which is a wholly owned subsidiary of Head Co. SPE Co was specifically formed to establish and operate Heart Gold Mine.Finance Co loans $2 billion to SPE Co. Under Finance Co's standard loan terms, Finance Co's rights of recourse in the event of default by SPE Co are not contractually limited. There are no collateral arrangements (such as a loan guarantee or letter of support from Head Co) in place in relation to this loan.SPE Co's assets comprise project assets of the Heart Gold Mine that are financed wholly by the $2 billion loan. SPE Co has no other substantial assets.Heart Gold Mine has not been profitable. No principal payments or interest repayments have been made on the loan. Five years into the loan arrangement, Finance Co decided to write off the loan as a bad debt. At the time of the write-off, SPE Co's assets have a market value of $200 million. However, the proceeds arising from the sale of these assets are not applied against the debt until the commencement of the year following the write-off of the loan.Up until the debt write-off, Head Co has claimed capital allowance deductions of $1 billion for the capital expenditure on project assets of the Heart Gold Mine. Tax consequences without the amendments Without the amendments Division 243 does not apply, since there is neither a contractual limitation on Finance Co's recourse to SPE Co's assets, nor a legal limitation on Finance Co's legal rights which arise otherwise than by contract.No adjustment needs to be made to the $1 billion capital allowance deductions already claimed by Head Co and Head Co is able to claim the remaining $1 billion of capital allowance deductions if SPE Co continues to be in operation.This is so despite the fact that SPE Co has not been fully at risk with respect to the $2 billion of debt that financed the project assets, and has not repaid the debt.If the unpaid amount of the debt is not included in assessable income under another provision, the commercial debt forgiveness rules in Division 245 may apply to the debt. If those rules apply, the unpaid amount may be offset against amounts that could otherwise reduce Head Co's taxable income in the same or later income year. Tax consequences with the amendments With the amendments, the debt is a limited recourse debt as Finance Co's right of recourse is predominantly limited to the financed asset. As such, Division 243 applies, unless in all circumstances it would be unreasonable for the debt to be treated as a limited recourse debt.Consequently, the $1 billion capital allowance deductions claimed by Head Co is included in Head Co's assessable income in the year of the write-off of the debt. The $200 million application of proceeds realised from sale of SPE Co's assets against the debt in the following year would give rise to a $200 million allowable deduction for Head Co in that year.The remaining capital expenditure amounts of $1 billion that would otherwise be allowable in the following year and/or future years would be reduced such that no further amounts are allowable except where additional payments are made.
6.17 Subsection 243-20(6) provides that an obligation covered by subsection 243-20(1), (2) or (3) is not limited recourse debt if, having regard to all relevant circumstances, it would be unreasonable for the obligation to be treated as limited recourse debt. This subsection operates to ensure that a debt which is technically limited recourse because of the application of the amendments is not treated as a limited recourse debt for the purposes of Division 243 where, in a practical sense, the debtor is fully at risk with respect to the loan or the financed expenditure.
6.18 The explanatory memorandum to the Taxation Laws Amendment Bill (No. 5) 1999 provide examples of circumstances where subsection 243-20(6) may apply. Paragraph 2.75 of the explanatory memorandum stated that:
'It might be unreasonable to apply new Division 243, for example, if all but a very minor component of a debtor's relevant deductible capital expenditure has been funded by limited recourse debt and, in a practical sense, the debtor is fully at risk of loss for the expenditure. The debt would not, in a practical sense, be limited recourse if it is fully secured by assets other than the financed property.'
Application and transitional provisions
6.19 The amendments made by this Schedule apply in relation to debt arrangements terminated at or after 7.30 pm (AEST) on 8 May 2012. [Schedule 6, item 4]
STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS
Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011
Limited recourse debt
6.20 This Schedule is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .
6.21 This Schedule amends the Income Tax Assessment Act 1997 by clarifying that a debt is a limited recourse debt if it is reasonable to conclude that the rights of the creditor as against the debtor upon default in payment are, in substance or effect, limited wholly or predominantly to rights relating to the financed property or property provided to secure the debt, having regard to certain factors.
Human rights implications
6.22 This Schedule does not engage any of the applicable rights or freedoms.
6.23 This Schedule is compatible with human rights as it does not raise any human rights issues.
Assistant Treasurer, the Hon David Bradbury