Supplementary Explanatory Memorandum and Correction to the Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
The following abbreviations and acronyms are used throughout this supplementary explanatory memorandum.
|ADI||authorised deposit-taking institution|
|ATO||Australian Taxation Office|
|Commissioner||Commissioner of Taxation|
|ITAA 1936||Income Tax Assessment Act 1936|
|ITAA 1997||Income Tax Assessment Act 1997|
|TAA 1953||Taxation Administration Act 1953|
General outline and financial impact
The amendments to the New Business Tax System (Debt and Equity) Bill 2001 will ensure the debt/equity measures operate as intended. There are a number of amendments as a result of the consideration of submissions received after the bill was introduced into the Parliament on 28 June 2001. Other amendments are of a technical and clarifying nature.
Date of effect: 1 July 2001 for amendments to the New Business Tax System (Debt and Equity) Bill 2001. However, for interests issued before 1 July 2001 the existing legislation will apply until 1 July 2004 unless the issuer of such interests makes an election that the rules contained in the New Business Tax System (Debt and Equity) Bill 2001 apply from 1 July 2001. Under a further transitional rule, the amendments will not apply until 1 January 2003 for certain at call loans.
Proposal announced: Not previously announced.
Financial impact: The financial impact of these changes will be a cost to the revenue of $3 million per year for the 2003 to 2005 taxation years. This impact is due to the change in the treatment of co-operative capital units.
Compliance cost impact: The amendments will involve no additional compliance costs. Changes to the transitional rules will reduce the compliance costs of issuers of interests issued before 1 July 2001. The amendments will also reduce the compliance costs of the parties to at call loans that are not affected by the amendments until 1 January 2003.
Chapter 1 - Amendments to the New Business Tax System (Debt and Equity) Bill 2001
1.1 The New Business Tax System (Debt and Equity) Bill 2001 contains rules for determining what is an equity interest in a company and what is a debt interest. The debt and equity tests determine whether a return on an interest in an entity may be frankable and non-deductible (like a dividend) or may be deductible to the entity and not frankable (like interest).
Amendments 1 to 4, 6 and 7
1.2 These amendments are to clarify the circumstances in which a return on a debt interest in the form of a dividend is deductible in accordance with section 8-1.
1.3 A return on a debt interest will not be prevented from being a deduction under section 8-1 merely because the return is contingent on economic performance (e.g. based on available profits) or secures a permanent or enduring benefit. Where the return on a debt interest is in the form of a dividend its deductibility is determined on the assumption that the dividend is a payment of interest.
1.4 For interest to be deductible, it must be incurred in gaining or producing the assessable income of the taxpayer, or necessarily incurred in carrying on a business for the purpose of gaining or producing the taxpayers assessable income. Moreover, the interest must not, for example, be of a capital, private or domestic nature if it is to be deductible.
1.5 This amendment clarifies that the provision is comparing the annually compounded internal rate of return of an interest with the benchmark rate of return.
Amendments 8 and 9
1.6 These amendments are to make it explicit that a dividend on an equity interest is not deductible, unless there is a specific provision that provides for deductibility. This is to reflect the converse of the situation provided for in section 25-85 whereby a dividend on a debt interest may be deductible under section 8-1.
Amendments 10 and 14
1.7 These amendments ensure that the objects of the Division are more clearly stated. Consultation indicated that there was some uncertainty regarding whether these subsections were objects of the Division.
Amendments 11 to 13 and 15
1.8 The income tax law differentiates between debt and equity. As the amendments note, a particular consequence of this is that, absent a specific provision, interest on a typical form of debt, namely an ordinary loan, may be deductible but is not frankable. Conversely, absent a specific provision, a dividend on an ordinary share may be frankable but is not deductible. An object of new Division 974 is to preserve this general dichotomy, notwithstanding new forms of instruments such as debt/equity hybrids, which can blur and even mask the distinction between debt and equity.
1.9 These amendments highlight that the test of whether a scheme or schemes give rise to either a debt interest or an equity interest is not to be approached by focusing on their mere legal form at the expense of the economic substance of the rights and obligations in respect of the scheme or schemes.
1.10 This is not to say that the form of the particular interest is to be ignored; often the form is consistent with, and indicates, what the substance is. However, attention merely to the form can mean that the general distinction between the tax treatment of debt and equity can be undermined by, for example, deductible returns on equity or frankable returns on debt. The emphasis on the economic substance of the rights and obligations is designed to provide a robust approach to determining, for example, whether there is an effective obligation of an issuer to return to the investor an amount at least equal to the amount invested.
Amendments 16 to 18 and 48
1.11 Amendments 16 to 18 clarify that the Commissioner must have regard to the first 3 objects when exercising the power to make a determination in relation to the measures contained in this bill.
1.12 One of the determination provisions (subsection 974-15(4)) allows the Commissioner to determine whether it would be unreasonable (see amendment 12) for subsection 974-15(2) to apply so that 2 or more related schemes give rise to a debt interest. In making this determination, the Commissioner must, for example, have regard to the economic substance of the rights and obligations arising under the scheme or schemes, and to whether or not combining the effect of the related schemes would allow the debt or equity tests to be circumvented.
1.13 Amendment 48 provides that the Commissioner may make a determination on his or her own initiative or the issuer may make a written application for a determination. If the issuer of an interest is dissatisfied with a determination made by the Commissioner, the issuer may appeal the decision in accordance with Part IVC of the TAA 1953.
Amendments 19, 41 and 42, 52 and 53
1.14 These changes mean that the Commissioner, when making a determination as to whether it is unreasonable to apply the related schemes provisions, is to also have regard to the related schemes (both individually and combined) in terms of their objective purpose and effects, the rights and obligations of the parties to them and, where appropriate, to whether they effectively constitute a structured package that can be assigned to other investors. The Commissioner will also have regard to the objects in subsections 974-10(1) to (3) when making a determination.
1.15 Similar factors would be used in relation to the power to make determinations under section 974-150 that what would otherwise be a single scheme is to be treated for the purposes of Division 974 as 2 or more separate schemes.
1.16 Experience obtained in the making of these determinations may be used in the development of general guidelines as to the sorts of circumstances in which determinations are made.
1.17 The insertion of the hedging rule by this amendment will ensure that for the purposes of the thin capitalisation rules contained in the New Business Tax System (Thin Capitalisation) Bill 2001, an instrument that hedges or manages the financial risk of a scheme or schemes (the underlying position) is not to be treated as being related to the scheme or schemes, where:
- the underlying position is already a debt interest; and
- the underlying position together with the hedge also constitutes a debt interest.
Example 1.1 Where a floating rate loan is hedged using an interest rate swap the floating rate loan and the interest rate swap will not be regarded as related schemes for thin capitalisation purposes.
Amendments 21 to 28
1.18 These amendments clarify that for the purposes of applying the debt test the relevant financial benefits to be received are those where another entity has an effectively non-contingent obligation to provide those financial benefits. The relevant financial benefits to be provided are those that an entity or connected entity has an effectively non-contingent obligation to provide.
Amendments 29, 30, 32 to 35 and 43
1.19 These amendments will remove the non-arms length dealing provision which was contained in proposed section 974-25. At the same time, they will ensure that certain common at call loans (that might have been entered into on a non-arms length basis) give rise to a debt interest and not an equity interest in a company until 1 January 2003. The purpose of this transitional period is to address industry concerns about having sufficient opportunity to review and organise such arrangements so that they fall on the particular entitys preferred side of the debt/equity border.
1.20 An at call loan is a loan repayable on demand by the lender. Under the proposed debt/equity rules, an at call loan would normally be classified as an equity interest where the return of either the principal or interest is at the discretion of an associate. While the loan could also satisfy the debt test, and therefore qualify as a debt interest as a result of the debt/equity tie-breaker test, this would be unlikely to be the case where the term is greater than 10 years and, as is common in such arrangements between associated parties, interest is nil, very low or is as determined by the parties from time to time.
1.21 This amendment will expand the exclusion for short term credit arrangements. That is, where the reason for not paying within the 100 day period is due to the neglect or inability (rather than unwillingness) to make the payment, the scheme will not be a debt interest. In this context, the neglect of a debtor will be considered to arise where, despite the debtor taking reasonable care to ensure that the payment would be made within the 100 day period, the payment is not made within that period due to an oversight.
Amendments 36 and 37
1.22 These amendments have the effect of requiring the debt test to be applied in a unit of account other than Australian dollars where there is a scheme under which all the financial benefits provided and received are denominated in either a particular foreign currency or a unit of account other than Australian dollars.
1.23 The intention of the debt test is that it will apply to foreign currency denominated loans as well as loans denominated in other units of account, for example, ounces of gold. In particular, commodity loans are intended to be debt interests.
Example 1.2 An entity borrows 100 ounces of gold, and has an obligation to repay 105 ounces of gold in the future. The unit of account for the borrowing is ounces of gold. For the purposes of the debt test the value of the financial benefit received is 100 ounces and the value of the financial benefit to be provided is 105 ounces.
1.24 This amendment will clarify that, before the Commissioner can exercise the power under section 974-65 to make a determination that a scheme will be a debt interest, the scheme must satisfy all the conditions of the debt test (in particular that the scheme must be a financing arrangement) except one. In particular, the amendment requires that the scheme be a financing arrangement. The exception is the requirement that it is substantially more likely than not that the value provided will be at least equal to the value received.
Amendments 39 and 40
1.25 The change to the heading will clarify that this provision may also apply to related schemes that are taken to give rise to a notional scheme.
1.26 The amendment to the note will make it clear that paragraph 974-70(1)(b) may apply to a notional scheme that arises under subsection 974-70(2).
1.27 The inclusion of paragraph 974-80(1)(ca) will ensure that there is a threshold requirement that the scheme be a financing arrangement in order to be classified as an equity interest. The provision in which this amendment appears deals with an equity interest arising from arrangements funding returns through connected entities. If the interest is not a financing arrangement it cannot be an equity interest.
1.28 The amendment of paragraph 974-80(1)(d) is a technical amendment that will ensure that the provision applies as intended, which is only in those cases where the scheme or schemes are deliberately designed so that the return to the connected entity is in turn used to fund either directly or indirectly a return to the ultimate recipient.
1.29 This means, generally speaking, that section 974-80 would not apply unless there is a plan constituted by documented rights and obligations that provide for the direct or indirect funding of a return to the ultimate recipient. A lack of documentation would not preclude the application of the provision if the design was clear from the surrounding facts and circumstances. However, mere association between the parties would not be a sufficient indicator of the relevant design.
1.30 This amendment ensures that the test for the determination of an equity interest will only be satisfied if the interest does not form part of a larger interest which is characterised as a debt interest. The amendment clarifies the current wording and policy intent of the section.
Amendments 46 and 47
1.31 The amendments to section 974-105 clarify the intended scope of this section, which applies for the purposes of the other provisions of Division 974 and other provisions of the ITAA 1997 whose application relies on an expression whose meaning is given by Division 974.
1.32 This amendment will broaden the scope of what constitutes a financing arrangement to include a scheme that funds a part of another scheme that is a financing arrangement or a return or part of a return on another financing arrangement. This will ensure that the definition of a financing arrangement is not limited only to a scheme which funds the whole of another scheme. A scheme therefore merely needs to supplement the return on another financing arrangement, as opposed to contributing to its capital, in order to be considered as a financing arrangement.
1.33 This amendment ensures that certain leases and bailments of property are excluded from giving rise to financing arrangements. This exclusion does not apply to lease arrangements or bailments that are treated as debt under the existing law, for example, property to which Division 16D of Part III of the ITAA 1936 applies.
1.34 This amendment will provide a regulation making power to provide a basis for the exclusion of particular schemes from the definition of financing arrangement and for specifying particular circumstances where a scheme will not give rise to a financing arrangement. The regulations will take into consideration the objective purpose of the transaction and will be consistent with the first 3 objects of the measures.
Amendments 54 and 69
1.35 These amendments clarify that for the purpose of the debt interest and equity interest provisions there is a distinction to be made between a return on such an interest and a return of the amount invested in the interest. In particular, a return on the interest does not include a return of the amount invested in the interest.
1.36 This amendment will enable returns on co-operative capital units issued by co-operatives to be frankable in the same manner as other non-share dividends.
1.37 This amendment extends the scope of the provision so that it also applies where an ADIs non-share equity interest combined with related schemes to form part of Tier 1 capital as classified by the Australian Prudential Regulation Authority. The amendment will also ensure that the provision applies in situations where a non-share equity interest (either by itself or in combination with related schemes) issued through the permanent establishment does not qualify as Tier 1 capital on a solo basis but forms part of the Tier 1 capital of an ADI on a consolidated basis.
Amendments 57 to 68
1.38 These amendments reduce taxpayers compliance costs by extending the period in which to comply with the transitional provisions from 28 to 90 days after the date of Royal Assent of this bill. To further reduce taxpayers compliance costs and the administrative burden, the issuer of an interest will be able to choose, subject to certain requirements, whether to make an election to have the new law apply to an instrument issued before 1 July 2001. If an issuer chooses not to make that an election in relation to an interest, the old law will apply to it until 1 July 2004. If an issuer chooses to elect that the new law applies, they will be required to provide the ATO with details of the particular transaction.
1.39 The Commissioners discretion in relation to the transitional rules has been broadened to permit the Commissioner to allow an issuer further time to make an election where it is reasonable, for example to allow for the correction of unintended errors in providing information or errors in making the election.
1.40 A separate election does not have to be made for each debt or equity interest. An election that refers to a class of interests, that is, interests of the same type, would be considered to be in relation to each of the interests. For example, an issuer may make an election for all 10 million convertible notes rather than make an election for each convertible note. All transitional elections made by an issuer may be lodged together.
1.41 Delete paragraphs 2.61 to 2.66 and 2.154 of the explanatory memorandum.
1.42 Delete paragraph 2.177 of the explanatory memorandum and replace it with the following paragraph:
"2.177 There is an effectively non-contingent obligation to provide a financial benefit for these purposes if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action. [Schedule 1, item 34, subsection 974-135(1)] "
1.43 Insert the following sentences at the end of paragraph 2.181 of the explanatory memorandum:
"This is not, however, intended to indicate that an interest-free loan between associated parties necessarily gives rise to a contingent obligation. Thus, the effectively non-contingent obligation test is not intended to disturb what was decided in Total Holdings (Aust) Pty Ltd v Federal Commissioner of Taxation (1979)
9 ATR 885. As a general statement, the taxpayers intention and the context of the arrangement are relevant in construing whether an effectively non-contingent obligation is present. In this regard, the substance approach adopted in judicial decisions such as Ure v Federal Commissioner of Taxation (1981)
11 ATR 484 is more consonant with the intent of the debt (and equity) test than that adopted in decisions such as Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd (1978)
8 ATR 879."
1.44 After Example 2.25 of the explanatory memorandum add the following paragraph:
"New subsection 974-65(1) would, however, not apply to ordinary shares just because the income of the issuing company is relatively certain. Where a share is non-redeemable and dividends are contingent on profits, it could not be said that there is an effectively non-contingent obligation that constitutes a substantial part of the issue price of the share. An essential pre-condition for the operation of this provision is therefore absent."
1.45 Delete the fourth and fifth sentences of the last paragraph of Example 2.36 of the explanatory memorandum (in paragraph 2.208) and replace them with the following sentences:
"Although the securities borrower in substance borrows securities, generally it cannot be said to have raised finance by the borrowing of shares, even if the arrangement does not fall within section 26BC of the ITAA 1936. If the arrangement does fall within that provision, paragraph 974-130(4)(b) specifically excludes it from being treated as a financing arrangement. On the other hand, if the securities borrower transfers cash to the securities lender, typically as collateral for the securities loan arrangement, with that amount of cash to be returned at a future date together with interest or similar amount paid to reflect the time that the securities lender has the cash (typically net of the securities loan fee), the cash transaction is a financing arrangement."