House of Representatives

Income Tax Assessment Bill 1970

Income Tax Assessment Act 1970

Second Reading Speech

by the Treasurer, The Honourable Leslie Bury, M.P.

The purpose of this Bill is to amend the income tax law so that interest on borrowings convertible into share capital will be allowable tax deductions, if the borrowings meet specified tests.

Since amendments to the income tax law in 1960, interest on convertible borrowings has not been a deduction for income tax purposes. The deductions were withdrawn to protect the revenue against legal tax avoidance. On the terms on which most convertible issues were being made in Australia prior to 1960 they amounted to no more than deferred equity issues. In effect, in the majority of cases tax deductible interest payments were simply being substituted for non-deductible dividend payments for the purpose of reducing tax payments by companies.

Last year the Government undertook a review of the income tax law on convertible borrowings with the objective of restoring tax deductions for interest in a way which would not provide the means of exploiting the conversion technique for tax-saving purposes so commonly adopted before 1960, but would allow companies to use convertible securities where that class of security met the needs of borrowers and lenders and consequently enabled companies to raise finance on favourable terms. In making this review we took account of the fact that convertible borrowings that replace what would otherwise be straight fixed interest borrowings do not in any way prejudice the income tax revenue.

We had in mind too that the convertible type of security can be a particularly appropriate means of financing development and expansion of Australian resources. During periods of development or expansion a company is usually unable to declare attractive dividends and, while it may have bright prospects, it is often handicapped in seeking to raise equity capital and must, therefore, rely upon debt finance. If, by a judicious use of fixed-interest borrowings carrying options to convert into equity capital, it can reduce the cost of servicing capital until it has reached a stage of profitability where it can pay attractive dividends, it might be able to obtain the capital more readily. If Australian investors are given the opportunity to invest in this way, they could eventually acquire equity participation in the companies concerned rather than fixed-interest investment.

From an investor's standpoint, convertible borrowings combine the advantages of a fixed-interest issue, in terms of income and security, with the opportunity of later conversion into share capital if the company performs successfully. They, therefore, provide an attractive 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.

Following the review of the matter in 1969, the Prime Minister announced on 16 September 1969 that income tax deductions would be restored for interest on convertible borrowings if the borrowings were made on terms which satisfied a series of tests that he then stated. These tests were designed with Australian convertible borrowings, rather than convertible borrowings raised overseas, principally in mind. Particularly in view of the establishment of the Australian Industry Development Corporation, the Government has reviewed the appropriateness of the tests so far as overseas convertible borrowings are concerned. Consistently with the necessary objective of protecting the income tax revenue from the results of use of convertible borrowings purely for tax saving purposes, we found it desirable to change some features of the original plan so as to cater more appropriately for convertible borrowings raised overseas rather than in Australia. It was also found desirable, mainly as a consequence of the revised tests relating to overseas borrowings, to make some minor amendments to the tests as they affected Australian borrowings.

I turn now to the basic conditions specified in the legislation as required to be met by a convertible borrowing if interest on it is to be tax deductible. One of these is that the option to take up shares in the borrowing company or another company must rest with the lenders and not with the company. It is, of course, a normal characteristic of fixed-interest borrowings that a lender has the right to receive repayment in cash. This condition recognises this fact and, at the same time, impedes attempts to legally avoid tax by schemes designed to give a deferred share issue the semblance and guise of a fixed-interest borrowing.

Another basic condition is that any period of time in which the lender is precluded by the terms of an issue 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. While a two-year no-option period is thus permissible, once that period expires the option must be exercisable up to the twelve month period preceding the date of maturity of the borrowing. It will not, however, affect the tax consequences if the option is exercisable at intervals of no more than twelve months, or at all times. These provisions seek to strike a balance between the financial needs and administrative convenience of borrowing companies and the interests of lenders to them.

Allied with the option provisions I have been discussing is a condition that the last date for exercise of the option must be no later than ten years after the date of offer of the convertible securities. It is considered that this span of time is wide enough to permit investment by a company in a development or expansion project to become profitable enough to justify a share issue.

A further basic condition - as to borrowings on the Australian market - is that the period for which the borrowing is made must not be less than seven years. This condition is not directly associated with taxation considerations. Its purpose rather is to ensure that companies, particularly foreign-controlled companies, that raise money on the Australian market, do not close off a loan, and thus the conversion option, before a project's development has reached the point where its future profitability is apparent to the Australian investor.

The minimum borrowing period will not be a test applicable to overseas raisings in foreign currency. The considerations that have been judged to make it appropriate for local raisings have no relevance to overseas raisings and, therefore, failure of an overseas raising to conform to a minimum duration will have no adverse tax consequences.

Another condition of a corresponding nature is that, for local borrowings, the terms and conditions of the issue must be fixed (as to interest rates and general conversion terms), and not subject to variation, throughout the period of the currency of the borrowing. This has been judged to be desirable so as not to permit, for example, changes in terms and conditions designed to induce the Australian lender to exercise his option to convert earlier or later than he might otherwise do. It has the purpose of making the lender's option real and not merely illusory and, in this way, supports the purposes of the minimum borrowing period that I have already referred to.

This condition has, however, been thought not to be an appropriate one to impose without modification for overseas raisings in foreign currency. Speaking broadly, it is a characteristic of certain types of overseas lendings that the loan contract provides that interest rates on the amounts lent are to be adjusted in relation to identifiable movements in particular international markets. The Bill provides that changes in interest rates on this basis will not have adverse taxation consequences in respect of overseas raisings in foreign currency. It also provides that any device incorporated in the terms of such an issue for the n purpose of making the conversion terms less favourable the longer convertible securities are held will not affect tax deductions. From a revenue viewpoint, the sooner dividends become payable to overseas investors instead of interest the better. Australian tax collections from both the lender and the borrower increase when this happens.

I turn now to the final basic condition. This is common to both local and overseas raisings and relates to the price at which convertible borrowings may be converted into shares. The Bill provides that the conversion price must not be less than 90 per cent of the market price of fully paid shares of the relevant class at the date of offer of the convertible securities, or the par value of such shares, whichever is the greater. It is to be noted that this is a floor price and, subject only to these prescribed minima, the actual conversion price is a matter for the company making the issue of the securities.

The shares into which the securities may be converted may be fully-paid shares of the company that issued the securities or of another company, e.g., a subsidiary, parent or associate. It will be of no significance whether the shares into which conversion is to be made on exercise of an option are issued to, and owned by, a third party or are to be first allotted on the exercise of the option.

The Bill provides machinery for the valuation of shares for the purposes of the conversion price test - both for shares quoted on Australian Capital City Stock Exchanges and those not so quoted. For quoted shares, the valuation period will ordinarily be the month that ends two weeks before the date of offer of the securities for subscription. If the shares were not traded in that month, 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 price on all Capital City Exchanges s in the valuation period.

For unquoted shares and quoted shares which have not been traded, provision is made for a valuation 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 one made to supplant an existing fixed-interest fixed-term borrowing.

I have arranged for a memorandum giving comprehensive explanations of the technical provisions of the Bill to be circulated to members before it is debated. I mention that the conditions proposed to be attached to deductibility of interest on convertible securities correspond to a large degree with the terms on which this type of security has in the recent past been issued overseas. The Government feels that the plan which has been devised will be of considerable help to developing companies and, at the same time, present a barrier to unwarranted tax savings through companies using convertible borrowings in lieu of share issues.

I commend the Bill to the House.