Explanatory Memorandum(Circulated by the authority of the Treasurer, the Hon John Dawkins, M.P.)
Deductible Losses on Disposal of Traditional Securities
Purpose of amendment: To prevent deductions being allowable for a capital loss on the disposal or redemption of a traditional security that is attributable to the inability or unwillingness of the issuer to discharge its obligations to make payments under the security. Losses incurred on the forgiveness of loans will not be treated as deductible losses on the disposal of traditional securities.
Date of Effect: The amendments apply to disposals or redemptions of traditional securities on or after 1 July 1992.
Sections 26BB and 70B are complementary provisions that deal with gains and losses on the disposal of traditional securities acquired after 10 May 1989. They require all gains to be included in assessable income (section26BB), and treat all losses as allowable deductions (section 70B). Profits and losses on the disposal of traditional securities are excluded from the coverage of the capital gains tax rules (subsection 160ZB(6)).
Traditional securities are, broadly, investments like debentures, bonds or loans that do not have a deferred income element. Securities issued under terms such that the investor's return on investment (other than periodic interest) will be no more than 1.5 per cent per annum are treated as not having a deferred income element.
That can be contrasted with securities that are subject to the accruals taxation regime contained in Division 16E. That Division applies to discount and other deferred income securities with a term exceeding one year and a likely return on investment (other than periodic interest) in excess of 1.5 per cent.
Sections 26BB and 70B were enacted to fill a gap that was perceived to exist following the introduction of Division 16E. While Division 16E provided an accruals basis for taxing income of longer term deferred interest, discounted or capital indexed securities, the treatment of similar gains from traditional securities was less certain, particularly in relation to taxpayers who were not traders in financial securities.
To counter the possibility that some gains on the disposal of traditional securities by non traders might be treated as capital gains - for example the sale of a bond, originally issued at par, in the secondary market at a premium - section 26BB specifies that the gains are included in assessable income. Conversely, section 70B authorises a tax deduction for losses on disposal. In these circumstances, for tax purposes the gains and losses are treated as the equivalent of a return on funds invested.
It was not intended that gains and losses of a genuinely capital kind would be affected by the traditional securities rules contained in sections 26BB and 70B. What was intended to be brought onto revenue account were gains and losses in value attributable to movements in interest rates or other market adjustment.
However, claims for deduction under section 70B have been sought for losses of the capital amount of an investment that relates to the inability or unwillingness of the financial institution or other borrower to meet its obligations under the terms of the security, that is, for capital losses due to default. Some capital losses in that category have been caused by failures of financial institutions and from the forgiveness of loans, the latter particularly in relation to inter group company loans or related partnership loans. In these kinds of circumstances, of course, there could be no corresponding assessable gain to which section 26BB could apply.
Section 70B is therefore being amended to ensure that capital losses on the disposal of a traditional security arising from the issuer's perceived inability or unwillingness to discharge payment obligations under the security are not deductible, nor losses incurred by waiving or releasing a debt [new subsections 70B(4) and 70B(5)].
There will be no such loss of deduction, however, in cases where the traditional security is a marketable security and the loss arises from a disposal that takes place in the ordinary course of trading on a securities market.
Application of those tests is assisted by the insertion of definitions of "marketable security" and "securities market". In combination, those definitions mean that marketable securities are stock, bonds, debentures, certificates of entitlement, bills of exchange, promissory notes or other securities that would be regularly sold, purchased or exchanged on a market, stock exchange or like facility [new subsection 70B(7)].
In other cases - that is, where the security is not sold routinely through a securities market - losses will not be deductible under section 70B if they are capital in nature and a reason for the disposal (or redemption) was an apprehension or belief (whether founded or unfounded) that the issuer of the security might default on its payment obligations under the security. That apprehension or belief could be based on the issuer's financial position or perceived financial position - whether or not such perceptions were generally held in the market place - or any other matter bearing on its likely ability or willingness to discharge its payment obligations [new paragraph 70B(4)(e)].
To make it clear that a loss incurred on the forgiveness of a debt due under a traditional security is not to be deductible under section 70B, the Bill provides that the waiver or release of a debt (or part of a debt) or other right under a security is not to be taken as the disposal or redemption of the security. That rule nullifies the operation of subsection 70B(2) which authorises a deduction for a loss only on the disposal or redemption of a traditional security [new subsection 70B(5)].
The "non-disposal" rule pertaining to debt forgiveness, however, must be read as applying strictly for the purposes of the operation of section 70B. Moreover, that rule is expressly not to be taken into account in interpreting the meaning of disposal or redemption in relation to transactions that occurred before 1 July 1992. In particular, it cannot be implied from the enactment of the rule that the waiver or release of a debt prior to 1 July 1992 constituted the disposal or redemption of a traditional security [new subsection 70B(6) and Clause 22].
Three new definitions are being inserted to facilitate the amendments being made to section 70B:
- "issuer" means the person who at any time has a liability to pay amounts under a security. The definition is relevant to the tests in new subsection 70B(4) relating to the financial position of the issuer and its ability or willingness to make payments under a security;
- "marketable security", as mentioned in the notes on new subsection 70B(7), is stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;
- "securities market", also mentioned in the notes on new subsection 70B(7), is a market, stock exchange or like facility through which marketable securities (as defined) would be regularly sold, purchased or exchanged. Such a facility would include networks of traders who may trade by telephone or computer links.
The effect of new paragraph 70B(4)(d) in conjunction with the expressions "marketable security" and "securities market" is that the deductibility of losses on the ordinary market disposal of securities that are tradeable on a securities market - whether or not the taxpayer is a securities trader - is not subject to the test in paragraph 70B(4)(e) relating to an apprehension or belief that the securities issuer might not discharge its payment obligations under the security.
Section 23E exempts from tax any premium paid on the redemption of Special Bonds issued by the Commonwealth. A reference in paragraph 23E(2)(b) to subsection 160ZB(6), which is being omitted by this Bill, is being deleted as redundant.
The effect of subsection 160ZB(6) is that gains or losses on the disposal of traditional securities affected by section 26BB or section 70B are not treated as capital gains accrued or capital losses incurred. In conjunction with the amendments being made by this Bill to deny deduction under section 70B for certain losses of a capital nature, subsection 160ZB(6) is being deleted. In relation to disposals of traditional securities after 30 June 1992, that means that subsection 160ZA(4) would operate to reduce the amount of a capital gain to the extent that such a gain was included in assessable income under section 26BB, in order to prevent double taxation. Section 160ZK would operate in a corresponding manner in relation to any capital loss that might also be deductible under section 70B by appropriately reducing the cost base of the relevant security.
The removal of subsection 160ZB(6) will also mean that Division 19A of Part IIIA (the capital gains rules) will apply, where appropriate, to loans which are traditional securities. For example, it will apply to eliminate multiple deductions for capital losses generated within a company group by forgiving loans that have been on-lent through various group companies.
The limits on deductibility under section 70B that are being implemented by this Bill apply only to disposals or redemptions of traditional securities that occur after 30 June 1992.