Edited version of your written advice

Authorisation Number: 1012718334264

Ruling

Subject: Cost-free debt capital

Question

Will the interest-free loans issued by XYZ Pty Ltd be treated as cost-free debt capital under subsection 820-946(2) of the Income Tax Assessment Act 1997?

Answer

No.

This ruling applies for the following periods:

Substituted accounting period ending 31 December 2015

Substituted accounting period ending 31 December 2016

Substituted accounting period ending 31 December 2017

Substituted accounting period ending 31 December 2018

Substituted accounting period ending 31 December 2019

The scheme commenced in:

Substituted accounting period ending 31 December 2014

Relevant facts and circumstances

XYZ Pty Ltd

1. XYZ Pty Ltd (XYZ) is an Australian based multinational group.

2. XYZ is owned by ABC Funds, A Pty Ltd (a wholly-owned subsidiary of ABC Funds) and B Trust.

3. XYZ is an Australian incorporated tax resident and the head company of the XYZ Australian income tax consolidated group.

4. In 20XX, XYZ was granted leave to adopt a substituted accounting period of 31 December. The change from a 30 June to 31 December balancer for income tax purposes was done to align reporting periods with its significant overseas businesses and to reduce the risk of consolidated budgetary uncertainty.

5. XYZ is an outward investing company subject to Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997).

Interest-free loans

6. XYZ has a number of interest-free loans on issue (the interest-free loans) with ABC Funds, A Pty Ltd and B Trust.

7. The purpose of these borrowings is for a combination of funding Australian and overseas projects and working capital requirements.

8. The interest-free loans have been on issue for at least 180 days.

Assumptions

9. The interest-free loans are debt interests for the purpose of Division 974 of the ITAA 1997.

10. The interest-free loans have not, and will not, give rise to 'costs', as defined in paragraph 820-40(1)(a) of the ITAA 1997 at any time.

11. The Lenders of the interest-free loans (the Holder):

(a) are outward investing entities (non-ADI) for the purpose of Division 820 of the ITAA 1997;

(b) are not a foreign entity as defined in subsection 995-1(1) of the ITAA 1997;

(c) have greater than $2 million of debt deductions for the purpose of section 820-35 of the ITAA 1997;

(d) have less than 90% of its assets located in Australia for the purpose of section 820-37 of the ITAA 1997;

(e) are not special purpose entities for the purpose of section 820-39 of the ITAA 1997; and

(f) are not an exempt entity as defined in subsection 995-1(1) of the ITAA 1997.

12. XYZ and the Holder will adopt the same method under Subdivision 820-G of the ITAA 1997 for calculating its average values for the purpose of Division 820 of the ITAA 1997, being either the 3 measurement days method in section 820-640 of the ITAA 1997 or the frequent measurement method in section 820-645 of the ITAA 1997.

13. One or more of XYZ's measurement days worked out under section 820-640 of the ITAA 1997 or section 820-645 of the ITAA 1997 (whichever the case may be) does not align with the Holder's measurements days. The measurement days are misaligned by no more than one day and is a result of XYZ having a 31 December year end and the Holder having a 30 June year end for income tax purposes.

14. The value of the interest-free loans, calculated under section 820-640 or section 820-645 of the ITAA 1997, on the pair of misaligned measurement days is the same (for example, the value of the matter on 30 June for XYZ is the same as the value of the matter on 1 July for the Holder).

15. The term of the interest-free loans will cross over the same number of measurement days and over the relevant pair of misaligned measurement days i.e. the term of the interest-free loans must cross over 30 June, 1 July, 31 December and 1 January.

16. The Holder will treat the interest-free loans, for the purposes of the thin capitalisation rules under Division 820 of the ITAA 1997, in a manner that is consistent with the treatment of the interest-free loans by XYZ. For example, if the interest-free loans, under this Ruling, are not cost-free debt capital for XYZ under subsection 820-946(2) of the ITAA 1997, the Holder will accordingly treat the interest-free loans as associate entity equity under section 820-915 of the ITAA 1997.

Relevant legislative provisions

Acts Interpretation Act 1901 Section 15AA

Income Tax Assessment Act 1997 Subdivision 820-G

Income Tax Assessment Act 1997 Section 820-35

Income Tax Assessment Act 1997 Section 820-37

Income Tax Assessment Act 1997 Section 820-39

Income Tax Assessment Act 1997 Paragraph 820-40(1)(a)

Income Tax Assessment Act 1997 Subsection 820-85(3)

Income Tax Assessment Act 1997 Section 820-640

Income Tax Assessment Act 1997 Section 820-645

Income Tax Assessment Act 1997 Section 820-915

Income Tax Assessment Act 1997 Subsection 820-946(1)

Income Tax Assessment Act 1997 Subsection 820-946(2)

Income Tax Assessment Act 1997 Subsection 820-946(3)

Income Tax Assessment Act 1997 Paragraph 820-946(3)(a)

Income Tax Assessment Act 1997 Paragraph 820-946(3)(b)

Income Tax Assessment Act 1997 Subsection 820-946(4)

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision

Cost-free debt capital

1. Interest-free loans are generally treated as quasi-equity for the purposes of applying the thin capitalisation rules in Division 820 of the ITAA 1997. This means that such debt interests are generally not included in the calculation of adjusted average debt of that entity and do not reduce assets when calculating the safe harbour debt amount (or the debt capacity) of the issuing (borrowing) entity. This recognises that although the funds are not equity, they provide capital to fund the entity's operations for which no debt deductions are claimed.

2. However, for XYZ these debt interests may be included in adjusted average debt, at step 5 of the calculation set out in subsection 820-85(3) of the ITAA 1997, as 'cost-free debt capital' where the requirements of subsection 820-946(2) of the ITAA 1997 are satisfied.

3. The Supplementary Explanatory Memorandum to the New Business Tax System (Thin Capitalisation) Bill 2001 (EM) states that the legislation includes integrity measures with respect to interest-free loans to ensure they are not used to manipulate the thin capitalisation rules.

4. The EM provides:

1.8 Thirdly, the meaning of adjusted average debt as calculated in the method statements is extended to include an integrity measure that recognises that where an entity receives short term interest-free debt funding, that funding may potentially be used to inflate the safe harbour debt amount of the entity. It is the ease with which such interest-free funding may be provided and removed that causes concern. Provided that both the entity providing and the entity in receipt of the interest-free debt are taking account of that arrangement for the purposes of ascertaining their respective safe harbour debt amounts and adjusted average debt, the interest-free debt will retain its equity like treatment and continue to be excluded from adjusted average debt.

5. Additionally, the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 4) 2002 which introduced the concept of cost-free debt capital into the thin capitalisation provisions states:

1.37 The effect of treating interest free loans as quasi-equity is that the borrower's assets (other funding remaining unchanged) increase without any corresponding increase to its adjusted average debt. This creates the opportunity for the safe harbour debt amount calculations to be manipulated by providing an interest free loan and then repaying it shortly after the borrowing entity's valuation day.

1.38 An integrity measure operates within the definition of adjusted average debt so that an interest free loan is included as adjusted average debt where the borrower and the lender do not use the same valuation days for thin capitalisation purposes. A valuation day is a day on which an entity measures the value of its assets, liabilities and debt.

Subsection 820-946(2) of the ITAA 1997

6. 'Cost-free debt capital' is defined in subsection 820-946(2) of the ITAA 1997 as follows:

The cost-free debt capital of the entity at a particular time during the relevant period is the total value of all the *debt interests *issued by the entity that satisfy all of the following:

(a) the interests are *on issue at that time;

(b) none of the interests gives rise to any cost, at any time, that is covered by paragraph 820-40(1)(a);

(c) each of the interests is covered by subsection (3) or (4) of this section at that time.

7. The interest-free loans issued by XYZ are currently on issue and do not give rise to any costs covered by paragraph 820-40(1)(a) of the ITAA 1997. The interest-free loans will therefore be cost-free debt capital if the conditions in either subsections 820-946(3) or 820-946(4) of the ITAA 1997 are satisfied.

Subsection 820-946(3) of the ITAA 1997

8. Subsection 820-946(3) of the ITAA 1997 provides:

This subsection covers a *debt interest or *equity interest held by an entity (the holder) at the particular time mentioned in subsection (2) or (2A) if:

(a) subsection (1) also applies to the holder for the period (the overlapped period) that is, or includes, all or a part of the relevant period; and

(b) for the purposes of applying this Division to both the holder and the issuer of the interest (the issuer), and in relation to only that part of the overlapped period that falls within the relevant period, either or both of the following apply:

(i) the *valuation days used to calculate the average value of the holder's assets are different from the valuation days used to calculate the issuer's *adjusted average debt;

(ii) the number of valuation days used to calculate the average value of the holder's assets are different from the number of valuation days used to calculate the issuer's adjusted average debt.

9. Paragraph 820-946(3)(a) of the ITAA 1997 will be satisfied where subsection 820-946(1) of the ITAA 1997 also applies to the holder of the debt interest.

10. Subsection 820-946(1) of the ITAA 1997 will apply to an entity for a period (the relevant period) that is all or a part of an income year if the entity satisfies all of the following:

(a) the entity is an *outward investing entity (non-ADI) or *inward investing entity (non-ADI) for that period;

(b) if the entity is a *foreign entity-the entity holds any of the following assets throughout that period:

(i) assets that are attributable to the entity's *Australian permanent establishment;

(ii) other assets that are held for the purposes of producing the entity's assessable income;

(c) neither section 820-35 ($250,000 debt deductions threshold) nor section 820-37 (exemption for entity with 90% Australian assets) prevents Subdivision 820-B, 820-C, 820-D or 820-E from disallowing any *debt deduction of the entity for the income year;

(da) for some or all of that period, the entity does not meet the conditions in subsection 820-39(3) (about exemption of certain special purpose entities);

(d) the entity is not an *exempt entity for the income year.

11. Based on the assumptions made for the purpose of this Ruling, subsection 820-946(1) of the ITAA 1997 will apply to the Holder of the interest-free loans for the period to which this Ruling applies. As there will be an overlap of the period to which subsection 820-946(1) applies to XYZ and the Holder, paragraph 820-946(3)(a) of the ITAA 1997 is satisfied.

12. XYZ has a (early) 31 December year end for income tax purposes. The 'overlapped period' for the purposes of paragraph 820-946(3)(a) of the ITAA 1997 for any given income year to which this Ruling applies will therefore be the period 1 January to 31 December (inclusive).The interest-free loans will be cost-free debt capital if the actual valuation days or the number of valuation days that fall within this overlapped period is different.

13. 'Valuation days' is defined in subsection 995-1(1) of the ITAA 1997 as 'the particular days at which the value of the matter is measured under subdivision 820-G for the purposes of that calculation'.

14. It has been assumed for the purpose of this Ruling that XYZ and the Holder will both adopt the same method under Subdivision 820-G of the ITAA 1997 for calculating its average values for the purpose of Division 820 of the ITAA 1997. This will be either the 3 measurement days method under section 820-640 of the ITAA 1997 or the frequent measurement method under section 820-645 of the ITAA 1997.

15. Using XYZ's 2016 income year as an example, XYZ and the Holder's 'valuation days' worked out under both of these methods are set out below:

(a) 3 measurement days method

Under the 3 measurement days method, the valuation days that would fall within the overlapped period for XYZ would be 1 January 2015, 30 June 2015 and 31 December 2015 whereas the Holder's would be 30 June 2015, 1 July 2015 and 31 December 2015.

(b) Frequent measurement method

Under the frequent measurement method using quarterly periods, the valuation days that fall within the overlapped period for XYZ would be 1 January 2015, 31 March 2015, 30 June 2015, 30 September 2015 and 31 December 2015 whereas the Holder's valuation days within this period would be 31 March 2015, 30 June 2015, 1 July 2015, 30 September 2015 and 31 December 2015.

The valuation days under the frequent measurement method using the regular intervals may consist of a fixed number of days or months (not less than one day and not more than 3 months) and each successive period of the same duration. Based on the assumption applied to this Ruling, the measurement day of the interest-free loan would be misaligned by no more than one day.

16. On a literal reading of subsection 820-946(3) of the ITAA 1997, under both the 3 measurement days method and the frequent measurement method, the interest-free loans would satisfy the requirements to be 'cost-free debt capital' as XYZ and the Holder would have 'different' valuation days in the overlapped period.

17. Specifically, the misaligned valuation days correspond to the 31 December/1 January and 30 June/1 July pair of days, which is a consequence of XYZ and the Holder having different year ends for income tax purposes.

18. This outcome arises even though the actual value of the matter (the interest-free loans) on the misaligned valuation days would be the same (based on the assumption applied to this Ruling). That is, the actual value of the interest-free loan for XYZ on its 1 January valuation day would be same as the value of the interest-free loan for the Holder on its 31 December valuation day. Similarly, the value of the interest-free loan on XYZ's 30 June valuation day would be the same as for the Holder on its 30 June and 1 July valuation days.

19. It has been argued that a strict literal interpretation of subsection 820-946(3) of the ITAA 1997 would produce an anomalous outcome that is incongruous with the policy intent of the law as it would have the consequence of making it impossible for a debt interest to qualify as anything other than 'cost-free debt capital' where the issuer and holder have different year ends, despite the fact that measurement of the matter may be identical.

Purposive approach to statutory interpretation

20. In determining the scope of a provision, an interpretation which best gives effect to the purposes or objects of the Act is to be preferred to another interpretation (Section 15AA of the Acts Interpretation Act 1901). The principle that the context in which a provision appears is a key consideration in determining the purpose or intent of that provision has been consistently applied by the courts (see e.g., Project Blue Sky Inc & Others v Australian Broadcasting Authority (1998) CLR 355).

21. Furthermore, it is accepted that context should be considered from the outset, not only once ambiguity as to the interpretation of a provision has been identified (CIC Insurance Ltd v Bankstown Football Club Ltd (1997) 187 CLR 384). Where a literal interpretation results in a provision operating in a way that is perceived as unintended, an alternative to the literal interpretation may be preferred. In Cooper Brookes (Wollongong) Pty Ltd v FCT (1981) 147 CLR 297, the High Court declined to adopt a literal construction which would have defeated the object or purpose of the enactment. Mason and Wilson JJ stated (at 321) that departing from the ordinary grammatical sense is not restricted to cases of absurdity or inconsistency:

… when the judge labels the operation of the statute as "absurd", "extraordinary", "capricious", "irrational" or "obscure" he assigns a ground for concluding that the Legislature could not have intended such an operation and that an alternative interpretation must be preferred. But the propriety of departing from the literal interpretation is not confined to situations described by these labels. It extends to any situation in which for good reason the operation of the statute on a literal reading does not conform to the legislative intent as ascertained from the provisions of the statute, including the policy which may be discerned from those provisions.

22. It is clear from the statutory context and the relevant explanatory material that step 5 of the adjusted average debt calculation in subsection 820-85(3) of the ITAA 1997 and subsection 820-946(2) of the ITAA 1997 was intended to be an integrity measure targeted at circumstances where interest-free loans are used to manipulate the debt and asset levels for the purposes of the thin capitalisation rules and produce a non-symmetrical outcome to the advantage of either the issuer or the holder.

23. Arguably, an interpretation of subsection 820-946(2) of the ITAA 1997 which is inconsistent with this would be contrary to the policy intent of the provision.

24. On a literal reading of paragraph 820-946(3)(b) of the ITAA 1997, XYZ and the Holder will have 'different' valuation days. The term 'different' is not defined in the income tax legislation. Accordingly, it takes on its ordinary meaning. The Macquarie Dictionary (6th edition) defines the term 'different' to mean, amongst other things:

1. differing in character; having unlike qualities; dissimilar.

25. In order to give effect to the purpose and intent of the cost-free debt capital provisions in subsections 820-946(2) and 820-946(3) of the ITAA 1997, it is therefore considered appropriate to depart from a more natural reading of the provision, and in particular, to the interpretation of the word 'different' in paragraph 820-946(3)(b) of the ITAA 1997.

26. Based on the particular facts and circumstances to which this Ruling applies and the assumptions on which this Ruling is based, given that XYZ's 1 January valuation day and the Holder's 31 December valuation day are adjacent to one another (i.e. they are only one day apart) and the value of the relevant debt interest (the interest-free loan), as calculated under section 820-640 or section 820-645 of the ITAA 1997, would be the same on these two days, it is considered that the two days are not 'differing in character', do not have 'unlike qualities' or 'dissimilar'. For the same reasons, XYZ's 30 June valuation day and the Holder's 1 July valuation day are also not considered to be 'different'. Adopting this approach in this case, provides a construction of subsection 820-946(3) of the ITAA 1997 that promotes the object and purpose of the legislation and is therefore a preferred construction.

27. Having regard to the statutory context, purpose and policy intent of subsection 820-946(2) of the ITAA 1997, the Commissioner will thus treat XYZ and the Holder's 1 January/31 December and 30 June/1 July pair of valuation days as not being different for the purpose of subsection 820-946(3) of the ITAA 1997. This interpretation will ensure that, provided XYZ and the Holder are taking into account the interest-free loans as intended for the purpose of determining their thin capitalisation positions and short-term interest-free loans are not used to manipulate the safe harbour debt amount, the interest-free loan will retain its equity like treatment and will be excluded from XYZ's adjusted average debt for the relevant period of the Ruling.

28. As the Commissioner has determined that the two valuation days are not 'different', for the purpose of applying paragraph 820-946(3)(b) of the ITAA 1997, the interest-free loans issued by XYZ will not satisfy the requirements of subsection 820-946(3) of the ITAA 1997 as XYZ and the Holder will not:

(a) use different valuation days to calculate the average value of its assets or adjusted average debt, or

(b) use a different number of valuation days to calculate the average value of its assets or adjusted average debt.

29. The interpretative approach applied here is not to be taken to be applicable generally to issuers of interest-free loans that operate under substituted accounting periods. The decision reached here is made on the very specific facts, circumstances and assumptions set out in this Ruling. A decision on how the law may operate to issuers of interest-free loans operating under substituted accounting periods in these situations is to be determined on the basis of the applicable facts and circumstances of each case.

Subsection 820-946(4) of the ITAA 1997

30. Subsection 820-946(4) of the ITAA 1997 only applies to a debt interest where subsection 820-946(1) of the ITAA 1997 does not apply to the holder of that debt interest. As subsection 820-946(1) applies to the Holder of the relevant debt interest in this case (based on the assumptions made for the purpose of this Ruling), subsection 820-946(4) is not applicable.

Conclusion

31. As the interest-free loans issued by XYZ are not covered by either subsections 820-946(3) or 820-946(4) of the ITAA 1997, they will not be treated as cost-free debt capital under subsection 820-946(2) of the ITAA 1997.

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