Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 7 - Distributions to beneficiaries and partners that are equivalent to interest
Overview
7.1 Schedule 7 to the Bill will amend section 45Z and other provisions of the Income Tax Assessment Act 1936 (ITAA 1936) to prevent trust or partnership distributions which are equivalent to the payment of interest on a loan from providing an entitlement to the intercorporate dividend rebate, franking credits or franking rebate.
Summary of amendments
7.2 The purpose of the amendments is to ensure that certain trust or partnership distributions which consist of dividends, but are effectively in the nature of interest, do not inappropriately carry franking benefits or receive the inter-corporate dividend rebate. The amendments will apply to taxpayers who hold a debt-like interest in shares indirectly through a trust or partnership; that is, to taxpayers who, under a trust or partnership, are effectively creditors rather than share owners. The amendments will curb the unintended usage of franking benefits and the inter-corporate dividend rebate by preventing the holders of indirect interests in shares from receiving those benefits for trust or partnership distributions consisting of dividends in the same circumstances in which direct holders of shares are denied those benefits for dividends. This will make the taxation treatment of such distributions consistent with the treatment of debt-dividends under existing section 46D of the ITAA 1936.
7.3 The amendments apply to interests created or acquired, and finance arrangements entered into, after 7.30 pm AEST on 13 May 1997, and to existing arrangements extended after that time.
Background to the legislation
7.4 Under existing section 46D, dividends (debt dividends) which may reasonably be regarded as equivalent to interest on a loan are not eligible for the inter-corporate dividend rebate; nor are debt-dividends frankable dividends (section 160APA provides that debt dividends are not frankable). This prevents arrangements to pay effectively tax-free dividends in lieu of interest. It also reflects a basic principle of imputation that company tax should only be imputed to owners of true equity interests in companies, and not to persons who are effectively creditors. Such persons do not bear the economic risk of holding shares to the same extent as shareholders.
7.5 Existing section 45Z generally extends the availability of the intercorporate dividend rebate to dividends derived indirectly through trusts and partnerships. An exception is where, as between the company paying the dividend and the trustee or partnership, the payment of the dividend is equivalent to the payment of interest on a loan. This exception does not, however, cover all cases where trust or partnership distributions consisting of dividends are equivalent to interest; for example, where the beneficiary or partner is receiving a distribution equivalent to interest, but the trustee or partnership is not. The Bill brings the taxation treatment of these cases into line with the existing treatment of other trust and partnership distributions of dividends which are interest-like in the hands of the trustee or partnership.
Explanation of the amendments
7.6 Schedule 9 of the Bill inserts new section 45ZA to deny the intercorporate dividend rebate in certain circumstances. Broadly speaking, this provision applies if a distribution is made to a taxpayer in respect of an interest in a trust or partnership, or under a finance arrangement, and, having regard to the way in which the amount was calculated, the conditions applying to the payment of the amount and any other relevant matters, that amount may reasonably be regarded as equivalent to the payment (or crediting or application) of interest on a loan. [Item 2, new section 45ZA]
7.7 The key elements of the new section are that
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- an amount must be included in the assessable income of a taxpayer; [Item 2, new paragraph 45ZA(1)(a)]
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- the whole or part of that amount must represent a dividend; and [Item2, new paragraph 45ZA(1)(b)]
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- the amount, or part of it, must be equivalent to interest on a loan. [Item2, new paragraph 45ZA(1)(d)]
7.8 In order to be captured by the new section the amount must also be either:
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- paid under a finance arrangement entered into after the commencing date; or
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- paid in respect of an interest created or acquired after the commencing date. [Item 2, new paragraph 45ZA(1)(c)]
7.9 Similarly, amended section 160APQ provides that where partnership or trust distributions are equivalent to interest, franking credits do not flow to the relevant corporate partners or beneficiaries. [Item 5, new section 160APQ]
7.10 For beneficiaries and partners that are not companies:
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- amended section 160AQX (franking rebate for beneficiaries of a trust who are resident individuals or registered organisations);
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- amended section 160AQY (franking rebate for certain trustees who are beneficiaries of a trust);
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- amended section 160AQYA (franking rebates for trustees of superannuation funds, approved deposit funds and pooled superannuation trusts who are beneficiaries of a trust or partners in a partnership);
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- amended section 160AQZ (franking rebate for certain partners);
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- amended section 160AQZA (franking rebate for certain life assurance companies who are beneficiaries of a trust or partnership);
provide that if the distribution from the trust or partnership is equivalent to the payment of interest on a loan, then no franking rebate or credit is to be allowed.
When is a distribution equivalent to interest on a loan?
7.11 For a distribution to be equivalent to interest on a loan there must be something analogous to a loan. Loan is defined broadly to include the provision of credit or any other form of financial accommodation, and thus includes financing arrangements not strictly loans at law, such as:
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- forbearing to collect payment of a debt which has fallen due;
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- the discounting of bills of exchange or promissory notes; or
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- the giving of a guarantee or surety.
It will therefore include cases where the party accommodated is not the party liable, or primarily liable, to repay the funds advanced, nor even the party liable to make payments in the nature of interest in respect of the accommodation. In particular, it will include cases where, under a financial arrangement, the person receiving financial accommodation is an associate of the trust or partnership making the distribution, or the company paying the dividend (and cases where the person receiving the distribution is an associate of the person providing the financial accommodation). [Item 2, new subsection 45ZA(4)]
7.12 Therefore the loan , or its equivalent, need not subsist between the taxpayer receiving the distribution, and the trust, partnership or company making it, for new section 45ZA and associated provisions to apply. However, to be equivalent to interest on that loan the distribution must be made in respect of it.
7.13 The relationship in the nature of a loan need not be an actual relationship of debtor and creditor as long as it is substantially equivalent to one. New section 45ZA is designed to deal with cases where the commercial and economic substance of a debt relationship has been replicated by obligations which do not amount in law to debt. For example, the right to receive a distribution in money or property at a later point in time equivalent in value to money or property supplied at an earlier point of time, or to call or put property at an agreed price equivalent to an amount paid previously for the property, may be equivalent in substance to a loan. Essentially anything which has the commercial effect of providing the borrower or accommodated party with the use of capital for a term may be equivalent to a loan; that is, anything equivalent to the hiring of money. [Item 2, new subsection 45ZA(4)]
7.14 Accordingly new section 45ZA and associated provisions encompass repayments by way of a provision for the repayment of the capital by a redemption, buy-back, distribution of capital, collateral payback or otherwise, including by way of understanding, guarantee, letter of credit or any other enforceable security.
7.15 Moreover, new subsection 45ZA(2) allows events occurring before or after the payment of the distributed amount which tend to indicate an equivalence to interest on a loan to be taken into account as other relevant matters under new paragraph 45ZA(2)(c) .
7.16 For example, if an instrument (such as a convertible redeemable unit in a unit trust) appeared to be redeemable only at the option of the issuer (the trustee) but statements are made by the issuer upon the announcement of the issue that a buyback is contemplated (eg. to avoid dilution of the ordinary shareholders equity), the provision would apply.
7.17 Similarly, if an announcement is made upon the issue of the units that a buyback of the shares allotted upon conversion of the units will be bought back, the provision would also apply.
7.18 Also, where the terms of the issue are such that a rational issuer would be commercially obliged to repurchase the units the arrangement may be effectively equivalent to a loan. It is a question of fact in each case whether, under an arrangement, temporary or permanent capital has been raised.
7.19 Having determined that there is something analogous to a loan, it must be determined whether the distributed amount is equivalent to interest on the loan (or other form of financial accommodation). Interest refers to a reward for the use of money over time. Where a financing arrangement not amounting to a loan in the strict sense of the word (though falling within the extended definition of loan) is involved, interest will refer to a reward in the nature of interest for that provision of credit or financial accommodation. As in the case of section 46D, whether or not a distribution is paid (the distributed amount), in effect, in substitution for payments of interest under financing arrangements will be determined having regard to a number of specific criteria and any other relevant matters: new subsection 45ZA(2) . The specific criteria are:
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- the way in which the distributed amount was calculated; and
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- the conditions applying to the payment of the distributed amount.
These criteria invite consideration of whether the distribution has been calculated in a manner analogous to the manner in which interest is calculated, that is, as a rate over time in respect of a principal sum; and similarly, whether the conditions under which the distribution is made, are analogous to the terms and conditions under which interest is payable on a loan, or equivalent financial arrangement.
7.20 In determining whether a distribution is equivalent to the payment of interest on a loan regard would be had, for example, to whether:
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- the distribution is for a fixed or variable percentage of a capital sum provided to some person;
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- the distribution is cumulative; and
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- directly, or by means of a collateral arrangement, the investment of the beneficiary or partner, can be redeemed or effectively recovered.
7.21 For example, if the distributed amount is calculated as a percentage of the sum subscribed for the interest of the partner or beneficiary in the trust or partnership at a rate fixed at the time of subscription, so that the manner of calculation of the distributed amount corresponds with the calculation of interest, that would be a factor pointing clearly to equivalence to the payment of interest. (Similarly, if the distributed amount were calculated as a rate on a sum provided under a finance arrangement to an associate of the partnership or trust, that too would point to equivalence to interest.) Thus if a taxpayer subscribed money to a unit trust, and was entitled after 5 years to have his units redeemed for the amount subscribed (or bought at an equivalent price), and in the interim to receive distributions consisting of dividends at a certain rate with respect to the amount subscribed, it would be concluded that the distributed amount was equivalent to interest on a loan.
7.22 On the other hand, if a taxpayer subscribed money for units in a unit trust, which then invested the money in shares, and the unit holder was entitled to redeem or sell the unit at any time for a sum or price varying with the changing value of the shares, and until then to receive distributions of the dividends payable on those shares according to the beneficiaries proportionate interest in the trust, there would not, absent other factors, be an equivalence between the distributed amount and interest on a loan. [Item 2, new subsection 45ZA(2)]
7.23 New subsection 45ZA(4) provides that a finance arrangement is any arrangement (as defined) carried out for a purpose which includes enabling a trustee, partnership or company (or an associate of the trustee, partnership or company) to obtain finance or to obtain an extension of an existing finance arrangement. Finance may be raised, for example, by the issue of shares or the creation of an interest in a trust or partnership.
7.24 Whether one of the purposes of any particular arrangement was to enable the trustee, partnership or company (or an associate) to obtain finance is a decision that must be made objectively in each case, taking into account the surrounding circumstances. For example, the issue of an interest in the trust or partnership that is redeemable may fall within the definition of a finance arrangement. On the other hand, an interest which was not redeemable generally would not come within the scope of new section 45ZA unless circumstances existed to indicate that the interest is to be, or was likely to be, effectively redeemed or extinguished in future.
7.25 New subsection 45ZA(4) provides that associate for the purposes of the provisions has the meaning given by section 318 of the ITAA, but that it also includes controllers of trusts and members of wholly-owned company groups.
7.26 A person is a controller of a trust if:
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- the person beneficially owns, or is able in any way, whether directly or indirectly, to control the application of more than 50% of the interests in the trust property or in the trust income;
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- the person has the power to appoint or remove the trustee of the trust;or
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- the trustee of the trust is accustomed or under a formal or informal obligation act according to the wishes of the person. [Item 2, new subsection 45ZA(4)]
7.27 For the purposes of the associated provisions (ie. amended sections 160AQX, 160AQY, 160AQYA, 160APQ and 160AQZA ) the definitions of associate and finance arrangement are the same as the definitions outlined in new section 45ZA.
Interests in discretionary trusts
7.28 New subsection 45ZA(4) provides that, for the purposes of these provisions, an interest in a trust will include the right of a discretionary object to receive, at the trustees discretion, benefits under the trust. Accordingly, beneficiaries of a discretionary trust hold an interest in the trust if it holds shares and they can benefit from those shares (eg. because the trustee can distribute dividend income to them).
When is a partnership or trust amount paid?
7.29 For the purposes of these measures, a trust or partnership amount is paid where an amount is included in, or allowed as a deduction from, a taxpayers assessable income. Therefore, a distribution from a trust or partnership which is attributable to a dividend will be paid if the amount of the distribution will be included in the taxpayers assessable income. [Item 2, new subsection 45ZA(4)]
7.30 The reference to allowable deduction is intended to deal with the case where a partnership makes a net loss. Each partner will be entitled to a deduction for their share of the loss. If the partnership derives dividends or other franked distributions the amount of the loss will be reduced. The reduced deduction thus effectively includes the dividend in the partners assessable income.
7.31 If a partner or beneficiary is a non-resident, any interest-like distribution from the trust or partnership to which the measures apply will be subject to dividend withholding tax in the same way as if the relevant dividend had been unfranked. [Item 3, new subsection 128B(3A)]
Deduction where franking rebate disallowed
7.32 The amendments made by items 6 to 11 prevent partners and beneficiaries receiving a franking rebate for distributions to which the measures apply. However, because of the operation of the section 160AQT gross-up to the assessable income of the trust or partnership, the partners or beneficiaries assessable income would include a grossed-up amount for which they do not receive a franking rebate. To prevent this, a tax deduction is allowed which removes so much of the beneficiaries or partners share in the net income of the trust or partnership as relates to the gross-up. [Item 12, new section 160ARAC]
Regulation Impact Statement
1. Specification of policy objective
7.33 The policy objective is to prevent the unintended use of franking credits and the intercorporate dividend rebate by amending the ITAA 1936 to provide that if a distribution from a trust or partnership which is attributable to dividends is equivalent to the payment of interest on a loan, the relevant beneficiaries or partners will not be entitled to the intercorporate dividend rebate or franking benefits attaching to the distribution.
7.34 This measure forms part of a package of measures to prevent franking credit trading and dividend streaming which was announced in the 1997-98 Budget. The amendments apply from 13 May 1997.
2. Identification of implementation options
7.35 One of the underlying principles of the imputation system as introduced in 1987 is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them, undermines this principle. Similarly, dividend streaming (ie. the distribution of franking credits to select shareholders) undermines the principle that, broadly speaking, tax paid at the company level is imputed to shareholders proportionately to their shareholdings.
7.36 Trust and partnership structures can be set up that allow the streaming of franking credits to a third party; such structures can effectively allow the third party to receive interest-like returns that are fully franked. In contrast, investors who receive interest-like returns directly from a company are denied franking credits and the intercorporate dividend rebate under section 46D of the ITAA.
7.37 It is anomalous that equity benefits should flow to beneficiaries or partners who essentially have debt interests in the relevant trust or partnership holding shares while equity benefits are denied where the taxpayer holds a debt-like interest directly in the company. The proposed amendments to section 45Z and related provisions ensure that the treatment of such interests are consistent irrespective of whether they are held directly in a company or indirectly through a trust or partnership.
7.38 The amendments to the ITAA ensure that, consistent with the operation of section 46D, where:
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- the beneficiary of a trust becomes presently entitled to a share of the income of a trust estate or a partner in a partnership receives a share of the partnership income;
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- that share is attributable, wholly or partly, to dividends; and
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- the entitlement of the beneficiary to its share of the trusts income or the entitlement of the partner to its share of the partnerships income is equivalent to an entitlement to interest on a loan;
no entitlement to the intercorporate dividend rebate, franking credits or franking rebate will arise in respect of the distribution.
7.39 The amendments to section 45Z and related provisions are the only option for implementing the Governments policy objective.
Assessment of impacts (costs and benefits) of the implementation option
7.40 The proposed amendments will only affect those taxpayers (ie. beneficiaries or partners) who receive distributions which are equivalent to interest on a loan. Therefore, only those taxpayers that enter into such arrangements, and their tax advisers (eg. members of the legal and accounting professions), need to put their mind to the operation of the amended provision. It is unlikely that taxpayers will inadvertently trigger the operation of the provisions because the relevant arrangements are readily identifiable.
7.41 The proposed amendments will also impact on the ATO (in administering the rule), the Government (in that the revenue base will be protected) and non-residents and tax-exempt shareholders (whose ability to transfer franking credits will be hampered).
7.42 It is not possible to provide any numerical data on the numbers of taxpayers in particular stakeholder groups or the extent of their interests. This is because shares are often held through complicated trust, nominee or group company arrangements or funds are invested by fund managers on behalf of clients. Accordingly, underlying ownership is difficult to trace.
Analysis of the costs and benefits associated with the implementation option
7.43 The rule will only apply to taxpayers who enter into specific arrangements. This advantage will ensure that there will be minimal impact on genuine commercial transactions and taxpayers compliance costs will be kept to a minimum. Accordingly, the proposed amendments should not impose high compliance costs on taxpayers.
7.44 Taxpayers who enter into relevant arrangements will incur additional compliance costs in determining whether their distributions are equivalent to the payment of interest on a loan. However, the extent of the compliance costs which will be incurred by taxpayers will vary depending on the facts and circumstances of particular cases. Accordingly, no reliable data on the amount of these costs is available.
7.45 No reliable data on the extent of the administrative costs which will be incurred by the ATO is available, however, any costs that do arise are not expected to be high and would be met within the ATO's existing budget allocation.
7.46 As mentioned above, section 46D currently does not apply to trust or partnership distributions which are equivalent to interest on a loan. It is anomalous that, while section 46D prevents streaming directly to third parties, it is possible under the current law to achieve exactly the same effect if the third party invests in shares indirectly through a trust or partnership rather than directly in the company. It would therefore be more equitable to ensure that the same rules apply to beneficial owners of shares through trusts and partnerships as apply to direct shareholders.
7.47 The amendments will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and mis-use of the intercorporate dividend rebate. The amendments are part of a package of measures targeting franking credit trading and dividend streaming. In the absence of the measures, to the extent that the revenue base would not be protected, there would be a significant revenue loss. While it is not possible to provide an exact estimate of the revenue loss that already existed from franking credit trading and dividend streaming, $130 million a year has been factored into the forward estimates for 1998-99 and subsequent years to take account of the effect of the measures on existing activities.
7.48 The ATO and Treasury held extensive consultations with peak bodies representing taxpayers and the investment community (including bodies representing the tax profession, the ASX, merchant banks, superannuation and investment funds) shortly after the Budget announcement of the franking credit trading and dividend streaming measures.
7.49 The proposed amendments are an important element of the franking credit trading and anti-streaming measures announced in the Budget and they ensure that taxpayers do not gain an undue tax benefit from entering into arrangements involving franking credit trading and dividend streaming.
7.50 They implement this policy objective in a way that, as far as possible, minimises administrative and compliance costs while providing taxpayers with certainty. This is because as stated above only taxpayers which enter into particular arrangements need to comply with the measures.
The ATO will closely monitor developments to detect any emerging possibility of significant revenue loss/deferral or unreasonable compliance costs arising from the rules. In addition, the ATO has consultative arrangements in place to obtain feedback from professional associations and the business community and through other taxpayer consultation forums.