Edited version of private ruling

Authorisation Number: 1011610027567

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Subject: Allowable deductions for premiums

Ruling

Question One

Will a deduction be allowable under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the exchange premium incurred by the taxpayer which is a head company of an income tax consolidated group?

Answer

Yes. A deduction is allowable under section 8-1 of the ITAA 1997 to the extent the exchange premium is attributable to the existing bonds but not allowable to the extent the exchange premium is attributable to the new bonds.

Question Two

Will the borrower, a subsidiary member of the consolidated group, be required to withhold an amount, under section 12-245 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953) in relation to the exchange premium paid by the borrower to the bondholders?

Answer

Yes, the borrower will be required to withhold an amount, under section 12-245 of Schedule 1 to the TAA 1953 to the extent the exchange premium is attributable to the existing bonds but will not be required to withhold an amount to the extent the exchange premium is attributable to the new bonds.

This ruling applies for the following period:

Income Tax Year ending 30 June 2011

The scheme commences during:

Income Tax Year ending 30 June 2011

Relevant Facts and Circumstances

The scheme the subject of this ruling has been ascertained from the Private Ruling Application provided to the Commissioner.

The borrower is an Australian resident company that is a wholly owned subsidiary member of an income tax consolidated group.

The borrower issued supplementary prospectuses overseas (OS), in order to offer the bonds

The bonds are not secured by any of the borrower's or its corporate group's property or assets and are ranked equally with all other unsecured and unsubordinated indebtedness.

The net proceeds received by the borrower on the bonds issued were used to repay certain borrowings and to fund working capital.

The bonds do not constitute Qualifying Securities for the purposes of Division 16E of the Income Tax Assessment Act (ITAA 1936).

The borrower proposes to undertake a Partial Exchange Offer into New Notes plus Cash for existing bonds.

Bond Exchange Offer

The borrower proposes to make an offer to exchange existing bonds for New Bonds plus an exchange premium in the form of a cash sum.

The borrower will provide the appropriate exchange offer prospectus to bondholders as required by law and market practice and such exchange offer prospectus, together with a registration statement in respect of the New Bonds.

The offer will be subject to a maximum acceptance condition, under which the borrower's offer to exchange up to a certain percentage of the existing Bonds.

The offer will remain open for a minimum number of business days.

The New Bonds will be issued with the same principal and, as such the exchange will not result in any increase in the amount of the taxpayer's principal repayment obligations.

Exchange Price

The Exchange Price offered for each $X principal amount of the existing Bonds validly tendered and not withdrawn on or before the Early Tender Date and accepted for purchase will be the 'Early Exchange Consideration ', which will be payable on the Settlement Date.

The Exchange Price where bondholders validly tender after the Early Tender Date, but on or before the Expiration Date, will be the 'Late Exchange Consideration ', which will be payable to such bondholders on the Settlement Date.

The Early Exchange Consideration and the Late Exchange Consideration offered to bondholders will be calculated using a particular formula.

The Early Exchange Consideration payable to bondholders per $X principal of Bonds will equal:

'the discount value on the Settlement Date of the remaining principal and interest per $X principal amount of Old Notes through the maturity date of the Old Notes, using a particular formula.

Exchange Premium

The Late Exchange Consideration payable to bondholders who validly tender after the Early Tender Date is the Early Exchange Consideration less a certain amount (per $X of principal). The first $X of the Early Exchange Consideration or the Late Exchange Consideration worked out will be 'paid' in the form of a New Bond, with the balance of the Early Exchange Consideration or Late Exchange Consideration forming the 'Exchange Premium'.

All participating bondholders will also be paid accrued interest on the Bonds from the last payment date to the date of payment of the Exchange Premium.

Upon exchange, the borrower will cancel the Bonds acquired and will cease to exist.

The offer will be managed by a third party dealer manager.

Assumption

The bondholders have addresses outside of Australia.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 8-1(1)

Income Tax Assessment Act 1997 Subsection 8-1(2)

Income Tax Assessment Act 1936 Section 128A(1AB)

Income Tax Assessment Act 1936 Subsection 128A(1AC)

Income Tax Assessment Act 1936 Subsection 128A(1AD)

Income Tax Assessment Act 1936 Section 128B

Taxation Administration Act 1953 Schedule 1 section 12-245

Question One

Detailed reasoning

The consolidation single entity rule in section 701-1 of the ITAA 1997 applies for working out the head company's liability to income tax or for working out the amount of a loss made by a head company for the period during which a subsidiary entity is a member of a consolidated group. As the borrower is a subsidiary member of the taxpayer's consolidated group, the taxpayer as the head company will have its liability to income tax affected by deduction, or otherwise, in respect of the Exchange Premium.

Deduction under section 8-1 of the ITAA 1997 in respect of the Exchange Premium

Subsections 8-1(1) and (2) of the ITAA 1997 state:

'(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

'(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital nature; or

(b) it is a loss or outgoing of a private or domestic nature;

(c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt; or

(d) a provision of this Act prevents you from deducting it.'

Taxation Ruling TR 93/7: Income tax: whether penalty interest payments are deductible (TR 93/7) provides guidance in determining whether a 'penalty interest payment' is deductible under subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936) which has been rewritten as section 8-1 of the ITAA 1997. Paragraph 3 of TR 93/7 states that: 'A penalty interest payment is generally deductible under subsection 51(1) of the ITAA 1936 if:

(a) the loan moneys were borrowed for the purpose of gaining or producing assessable income or for use in a business carried on for that purpose; and

(b) the payment is made in order to rid the taxpayer of a recurring obligation to pay interest on the loan, where such interest would itself have been deductible if incurred.'

The deductibility requirement provided in paragraph 3(a) of TR 93/7 is similar to subsection 8-1(1) of the ITAA 1997 in that regard has to be given to the use of the loan moneys raised by the Bonds. The head company stated that the proceeds were used to repay certain borrowings and to fund working capital. Therefore, the funds were used by the taxpayer for the purpose of gaining or producing assessable income.

What remains therefore to consider is whether the exchange premium is a payment made in order to rid the taxpayer of a recurring obligation to pay interest on the Bonds, as provided in paragraph 3(b) of TR 93/7.

The Exchange Premium amount is only payable to the bondholders who accept the Exchange Offer.

As stated earlier, the interest rate payable on the existing bonds is above the current market interest rate and the bonds are trading at a premium to their face value.

The exchange premium is required to be paid to bondholders for exchanging higher coupon bonds for lower coupon bonds and the exchange premium includes an amount to compensate the bondholders for not receiving the higher coupon on their existing bonds.

In addition, the exchange premium includes an amount paid to bondholders in relation to exchanging their existing bonds for new bonds.

Exchange Premium in respect of Existing Bonds

Although the payment does present capital indicia, including being a once-and-for-all lump sum payment, it is not conclusive. Relevantly, paragraph 15 of TR 93/7 states:

"Where the advantage sought is the release from the contractual obligation to incur a recurrent liability to pay interest on the loan, and such interest would itself have been deductible, then the penalty interest payment is on revenue account (FC of T v. Marbray Nominees Pty. Ltd. 85 ATC 4750; (1987) 17 ATR 93, Metal Exploration Ltd. v. FC of T 86 ATC 4505; (1987) 17 ATR 786). Such a payment does display certain capital indicia in terms of the tests enunciated by Dixon J. in the Sun Newspapers case (supra); i.e. it is a once-and-for-all type lump sum which eliminates a threatened disadvantage and this produces a benefit of a lasting character for the taxpayer. Nevertheless, where the initiating cause for early repayment of the loan is saving in future interest outlays, the payment is essentially revenue in character."

In practical terms, an advantage sought by the corporate group in paying the Exchange Premium is that it will no longer be required to pay coupons above the current market interest rate on the existing bonds. Part of the Exchange Premium is a payment representing interest that the borrower would be required to pay on the existing bonds if the Bonds remained on issue.

This part of the Exchange Premium which represents the extent of ridding the corporate group of the recurring obligation to pay higher Coupons on the existing bonds is a payment to bondholders for exchanging higher coupon bonds for lower coupon bonds and, is therefore akin to a penalty interest payment as described in TR 93/7, payable by a borrower to the lender for early repayment of a loan.

Therefore, the Exchange Premium paid to the bondholders is deductible under section 8-1 of the ITAA 1997 to the extent that it is attributable to the existing Bonds (ie, to the extent it represents penalty interest).

Exchange Premium in respect to New Bonds

The further advantage sought by the corporate group in paying the exchange premium is to induce the existing bondholders to accept the bond exchange offer for new bonds. The new bonds will provide new loan funds which will replace existing loan funds previously used to repay certain borrowings and to fund working capital. The issue of new bonds is therefore an enduring benefit and considered to be capital in nature as there is a direct link to the establishment of the loan, being the issuance of the New Bonds.

This part of the Exchange Premium that does not represent the extent of the corporate group ridding itself of the recurring obligation to pay higher coupons is instead incurred in relation to bondholders accepting the new bonds and is therefore attributable to the new bonds.

Therefore the part of the Exchange Premium that represents an amount attributable to the New Bonds is not deductible to the head company under section 8-1 of the ITAA 1997 as this part, being akin to a borrowing expense, is considered capital in nature.

Question Two

Detailed reasoning

The consolidation single entity rule in section 701-1 of the ITAA 1997 only applies for working out the head company's liability to income tax or for working out the amount of a loss made by a head company for the period during which a subsidiary entity is a member of a consolidated group. In such a period, the subsidiary member is taken to be a part of the head company.

A liability to withhold (or collect) an amount of tax is not a matter relevant in working out the head company's liability to income tax or for working out the amount of a loss made by a head company.

Therefore, if necessary, the borrower, a subsidiary member of the consolidated group, is the relevant entity that will be required to withhold.

Section 12-245 of the TAA 1953

An entity must withhold an amount from interest [as that term is defined in Division 11A of Part III of the ITAA 1936 (Division 11A)] it pays to an overseas entity or entities pursuant to section 12-245 of Schedule 1 to the TAA 1953.

In Division 11A, 'interest' is defined in subsection 128A(1AB) of the ITAA 1936 to include an amount:

(a) that is in the nature of interest; or

(b) to the extent that it could reasonably be regarded as having being converted into a form that is in substitution for interest; or

(c) to the extent that it could reasonably be regarded as having being received in exchange for interest in connection with a washing arrangement; or

(d) that is a dividend paid in respect of a non-equity share; or

(e) if regulations under the ITAA 1997 are made having the effect that instruments known as upper tier 2 capital instruments, or a class of instruments of that kind, are debt interests - that is paid on such a debt interest and is not a return of an investment;

but does not include an amount to the extent to which it is a return on an equity interest in a company.

As the term 'interest' is not comprehensively defined for the purposes of Division 11A , it is therefore necessary to have regard to the nature of interest at common law.

Interest is in essence compensation to a lender for being kept out of the use and enjoyment of the principal sum (FC of T v The Myer Emporium Ltd (1987) 163 CLR 199). It is an amount that is calculated by reference to a principal sum (FC of T v The Myer Emporium Ltd at 207) and by reference to time (Federal Wharf Co Ltd v DCT (1930) 44 CLR 24 at 28; per Cooper J in Century Yuasa Batteries Pty Ltd v. FC of T 97 ATC 4299 at 4314).

Taxation Rulings TR 93/27: Income tax: basis of assessment of interest derived and incurred by financial institutions (paragraphs 24-30) and TR 2002/15: Income tax deductibility of payments incurred on moneys raised through the issue of perpetual notes (paragraphs 53-56), which provide guidance on the 'nature of interest, state that all of the following requirements must normally be satisfied for a payment to be treated as interest:

· there must be a sum of money by reference to which the payment is to be ascertained (which might loosely be called the principal sum or the principal debt);

· that sum must be a sum which is due to the person entitled to the interest; and

· the payment must be calculated by reference to time.

TR 2002/15 states at paragraphs 58 and 59:

· A debt is moneys outstanding to be repaid at a fixed or determinable time or on demand: 'Chitty on Contracts', 27th ed. 1994, paragraph 36-202.

· In FC of T v. Radilo Enterprises Pty Ltd 97 ATC 4151 at 4161; (1997) 34 ATR 635 at 646 the joint judgment of Sackville and Lehane JJ refers to Dr Pannam's description of a loan of money:

'A loan of money may be defined, in general terms, as a simple contract whereby one person ('the lender') pays or agrees to pay a sum of money in consideration of a promise by another person ('the borrower') to repay the money upon demand or at a fixed date. The promise of repayment may or may not be coupled with a promise to pay interest on the money so paid. The essence of the transaction is the promise of repayment. [emphasis added]

In their joint judgment of the Radilo case, Sackville and Lehane state that "Interest on a loan is of course ordinarily payable by a borrower regardless of the profitability of the borrower's business" suggesting that interest is cumulative and is not subject to profit or other contingency.

The Full Federal Court in FC of T v. Century Yuasa Batteries Pty Ltd 98 ATC 4380 held that an amount is not in the nature of interest if it was not calculated by reference to a principal sum (at 4383-4). The Court also said an amount is in the nature of interest if it in essence fits the description of the ordinary meaning of interest but is not called interest. An example is the discount on a security (see subsection 128A(1AC) of the ITAA 1936)

Subsection 128A(1AD) of the ITAA 1936 provides an example of an amount that is in substitution for interest. That subsection 'has the effect of deeming that lump sum payments made instead of payments of interest are amounts in substitution for accrued interest and are, therefore, interest for the purposes of the withholding tax provisions' (paragraph 2.65 of Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 2) 1997)

Further, the Commissioner set out in Interpretative Decision ATO ID 2008/153 his opinion in respect to a 'make whole' payment. In ATO ID 2008/153, the Commissioner concluded that an amount which represented the excess of the discounted value of interest payable during the remaining term of the Notes over the outstanding principal amount is interest for withholding tax purposes.

Exchange Premium in respect of Existing Bonds

Reference to a principal sum

The applicant stated that the consideration to be paid to bondholders will be calculated using a particular formula.

A component of Early Exchange Consideration is the exchange premium.

The definition implies that, in its most basic form, the exchange premium is calculated as the excess of the discounted value of the remaining payments due under a Bond (of both principal and interest) over the amount of the Principal.

It is clear from this formula that both the Early Exchange Consideration or Late Exchange Consideration and the exchange premium are based on a principal amount.

Exchange premium due to the person entitled to the interest

There is borrowing between the borrower and the foreign lenders. Those foreign lenders are entitled to interest from the borrower under the terms of the bonds initially issued under the Supplementary Prospectus. Furthermore, the exchange premium amount is only payable to those bondholders who accepted the Exchange Tender Offer.

Calculation by reference to time

Discounted value of the remaining payments is an important component in the Exchange Price calculation.

In the context of finance and economics, discounting is the process of finding the present value of an amount of cash at some future dates, and along with the compounding cash forms the basis of time value of money calculation. The discounted value of cash flow is determined by reducing its value by the appropriate discount rate for each unit of time between the time when the cash flow is to be valued and the contracted due time or times of the cash flow.

In this case, discounted value is a reduction of unpaid principal and unpaid future expected interest to present value at the Settlement Date, at a discount rate that reflects the time value of money.

The fact the payments due needed to be discounted to present value clearly shows that the exchange premium calculation is made by reference to time.

Conclusion in respect of existing Bonds

To the extent the exchange premium represents penalty interest payable to foreign bondholders for the existing bonds by the taxpayer an Australian resident company, is in the nature of interest or in substitution for interest for the purposes of subsection 128A(1AB) of the ITAA 1936 as:

· it is calculated by reference to the outstanding principal amount;

· the amount is due to the lender under the terms of the Cash Tender Offer; and

· the amount is calculated by reference to the time the loan would have been in place if there was no buy back of bonds.

Accordingly, this part of the exchange premium when payable to Bondholders with addresses outside Australia, the borrower will be required to withhold an amount under subsection 12-245 of Schedule 1 to the TAA 1953.

However, as set out in the note following section 12-245 for limits on the amount to be withheld, one should refer to section 12-300 of Schedule 1 to the TAA 1953.

Section 12-300 provides that an entity is not required to withhold an amount from an interest payment if no withholding tax is payable on the interest.

Exchange Premium n respect of New Bonds

As stated earlier the advantage sought by the taxpayer by paying this amount is to induce the existing bondholders to accept the bond exchange offer for new bonds. The new bonds will replace existing loans previously used to repay certain borrowings and to fund working capital. The part of the Exchange Premium that does not represent penalty interest is related to the issue of new bonds. This part is in relation to the issuance of new bonds which is akin to borrowing expenses for new loan funds and is therefore an enduring benefit which is considered to be capital in nature.

Conclusion in respect of New Bonds

To the extent the exchange premium represents an inducement to accept the new bonds, this amount is not in the nature of interest or in substitution for interest for the purposes of Division 11A of the ITAA 1936. Therefore, the subsidiary member will not be required to withhold an amount under section 12-245 of Schedule 1 to the TAA 1953 for this part of the exchange premium payable to Bondholders with addresses outside Australia.