The Senate

Income Tax Assessment Bill 1970

Income Tax Assessment Act 1970

Notes for the Minister's Second Reading Speech

This Bill proposes amendments to the Income Tax Law which will have the effect of reinstating income tax deductions for interest on borrowings convertible into share capital, if the borrowings meet specified tests.

The Income Tax Law relating to convertible notes was amended in 1960 to withdraw deductions for interest on borrowings convertible into share capital. This was done to protect the revenue against legal tax avoidance. In the majority of pre-1960 issues, companies were using convertible notes simply as a means of reducing their tax payments. On the terms on which convertible issues were commonly being made in Australia before the deduction was withdrawn they amounted to no more than deferred equity issues. Tax deductible interest payments were, in effect, being substituted for non-deductible dividend payments.

Last year the Income Tax Law on convertible borrowings was reviewed by the Government with a view to restoring tax deductions for interest in certain circumstances. The objective was to revive the use of convertible securities in corporate financing, where that class of security met the needs of borrowers and lenders and consequently enable companies to raise finance on favourable terms, but without, at the same time, reopening the opportunities for exploiting the convertibility technique purely for tax-saving purposes.

In making this review the Government had in mind that convertible borrowings that replace what would otherwise be straight fixed-interest borrowings are not in any way objectionable from a revenue standpoint. We also took into account the fact that this type of borrowing could be a particularly appropriate means of financing development and expansion of Australian resources. During periods of development or expansion a company may not be in a position to declare attractive dividends and, although it may have undeniable prospects, it is at a disadvantage in seeking to raise equity capital and must, therefore, rely upon detg finance. If, by appropriate use of the convertible type of security, it can lower the cost of servicing capital until profits are at a level where attractive dividends can be paid, it might be able to obtain its capital requirements more readily. Under this type of security, Australian investors would not be restricted to fixed-interest investment but would have access to equity in the companies concerned.

From an investor's standpoint, convertible borrowings couple the advantages of a fixed-interest borrowing, in terms of income and security, with the "sweetener" of being able to convert the borrowing into share capital if the company performs successfully. They can, therefore, be a particularly suitable means of investing in developing companies with good but, to some extent, uncertain prospects for future growth. This feature of them could well provide an opportunity for Australians to acquire equity holdings in overseas-owned ventures, e.g., in the extractive industries.

On completion of the Government's review of the matter last year, it was announced by the Prime Minister on 16 September 1969 that interest on convertible issues made after the law was amended would be deductible for income tax purposes if the terms of the borrowing satisfied a series of tests outlined in his statement. These tests for determining eligibility for the deduction of interest were designed with convertible borrowings raised in Australia, rather than convertible borrowings raised overseas, foremost in mind. Subsequently- and particularly in view of the establishment of the Australian Industry Development Corporation - the Government reviewed these tests to ensure that they were also appropriate for overseas convertible borrowings. In order to cater appropriately for convertible borrowings raised overseas, it was found desirable to modify some features of the original plan. We also found it desirable, mainly as a consequence of the revised tests applicable to overseas borrowings, to make some minor changes to the tests as they related to Australian borrowings.

I turn now to the basic conditions specified in the Bill. All of these must be met by a convertible borrowing if interest on it is to be deductible for tax purposes.

The first test is that the option to take up shares- which may be shares in the capital of the borrowing company or another company - must rest solely with the lender and not with the company. A normal characteristic of fixed-interest finance is, of course, that a lender has the right to receive repayment in cash. This test recognises this feature. At the same time, it will serve to impede legal tax avoidance by companies through their adoption of arrangements calculated to give a deferred share issue the semblance and guise of a fixed-interest borrowing.

The shares that are the subject of this option may be fully-paid shares of the company making the convertible issue or of an associated company, such as, for example, a subsidiary or parent company. It will be of no significance whether the shares into which the securities may be converted are issued to, and owned by, a third party, or are to be specially allotted to satisfy the exercise of the option to convert.

Another basic test to be satisfied is that any period of time in which the lender is precluded by the terms of a borrowing from exercising an option to take up shares must not extend for longer than two years from the date on which the convertible securities are offered for subscription. The terms of an issue may thus stay the exercise of the option to convert during the first two years of the borrowing, but after that initial period the option must be exercisable up to the twelve month period preceding the date of maturity of the borrowing. I mention that the tax consequences will be the same if the option is exercisable at all times during the option period, or at times during that period no more than twelve months apart. In this, we have had in mind to strike a balance between the financilt needs and administrative convenience of borrowing companies and the interests of lenders to them.

Linked with the option provisions I have mentioned is a test that the last date for exercise of the option must in all cases be no later than ten years after the date of offer of the convertible securities. This span of time is judged sufficient for investment by a company in a development or expansion project to become profitable enough to justify a share issue.

A further basic condition - but only as to borrowings on the Australian market - is that the borrowing is to have a currency of not less than seven years. This test is designed to ensure that companies, particularly foreign-controlled companies, that issue convertibles on the Australian market, do not prematurely close off a borrowing, and thus the lender's option to acquire shares, before a project's development has reached the point where its future profitability is generally known to Australian investors.

Overseas raisings in foreign currency will not, however be subject to this "minimum borrowing period" condition. The considerations that are felt to make the test appropriate for local convertible borrowings have no relevance to overseas borrowings.

Of a corresponding nature is the further test that, for convertible notes issued in Australia, the terms and conditions of the borrowing must not vary, but must remain fixed (as to interest rates and general conversion terms) throughout the period of the borrowing. But for this test, terms and conditions of the borrowing could be manipulated so as to induce Australian lenders to exercise conversion rights earlier or later than might otherwise have been the case. The test is designed to make the lender's choice of whether and when to exercise his option to convert real and not merely illusory.

This condition has, however, been thought not to be an appropriate one to impose without modification for overseas raisings in foreign currency. It is a feature of certand types of overseas borrowings that provision is made for interest rates payable on the borrowing to vary by reference to identifiable movements in particular international money markets. The Bill provides that changes in interest rates on a convertible borrowing under a provision of this nature will not have adverse taxation consequences in respect of overseas raisings in foreign currency. The Bill also provides that deductibility of interest on such an issue will not be affected if the terms of the borrowing contain features designed to make the conversion terms more attractive the earlier conversion takes place. From a revenue viewpoint, the sooner non-deductible dividends are substituted for deductible interest payments, the better - both the lender's and the borrower's Australian tax payments increase when this happens.

The final basic condition is common to both local and overseas raisings. This test specifies that the price payable for shares that may be acquired by the lender on the exercise of his option to convert must not be less than either the nominal (that is, the par) value of the shares or 90 per cent of the market price of the same kind of fully paid shares at a prescribed valuation date, whichever is the greater. It is to be noted that this is a floor price and, subject only to the prescribed minimum, the price payable for shares on the exercise of the conversion option is a matter for the company making the convertible issue.

The Bill sets out the basis of valuation of shares for the purposes of the conversion price test - both for shares quoted on Australian Capital City Stock Exchange and those not so quoted. For quoted shares, the valuation period will ordinarily be the month that ends on the prescribed "valuation date", that is, the date that is six weeks before the date of offer of the securities for subscription. If the shares were not traded in the month ending on the prescribed valuation date, but were traded in either of the two preceding months, the later of the months in which trading took place will be the valuation period. The value of the shares will be determined as their weighted average market prices on all Capital City Stock Exchanges in the valuation period.

For unquoted shares, and for quoted shares which have not been traded, the Bill provides that the valuation for purposes of the conversion price test is to be made by a registered company auditor in accordance with criteria specified in the Bill.

The amendments proposed by the Bill will apply to convertible securities to which subscriptions are made after the legislation receives assent, whether the convertible borrowing is an entirely new one or made to supplant an existing fixed-interest fixed-term borrowing.

Explanations of the technical provisions of the Bill are contained in a comprehensive explanatory memorandum being made available to Honourable Senators. The conditions proposed for restoring the income tax deduction for interest on convertible borrowings correspond to a large degree with the terms on which convertible securities have in recent times been issued on international markets. The Government feels that the plan resulting from its review of the Income Tax Law as it applies to convertible borrowings will offer worthwhile assistance to new and developing companies and, at the same time, present a barrier to unwarranted tax savings through companies issuing convertible securities in plain substitution for share issues.

I commend the Bill to the Senate.