Edited version of private ruling

Authorisation Number: 1011610045130

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Ruling

Subject: Allowable deduction for premiums

Question One

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

Answer

Yes.

Question Two

Will a 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 tender premium paid by the borrower to the bondholders?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2011

The scheme commences during:

Income Year ending 30 June 2011

Relevant facts and circumstances

The scheme the subject of this ruling, has been ascertained from the Private Ruling Application and various documents that were provided to the Commissioner.

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

The borrower issued supplementary prospectuses overseas (OS), in order to offer 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 16 E of the Income Tax Assessment Act (ITAA 1936).

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

Cash Tender Offer

The borrower proposes to purchase for cash the existing bonds.

The borrower will provide the appropriate offer documents to bondholders as required by law and market practice.

The offer will be subject to a maximum acceptance condition.

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

The rates of interest payable on the existing bonds are above the current market interest rates for comparable debt securities. As such, the bonds are currently trading at a premium to their principal value. It is expected therefore the cash sum paid by the borrower to repurchase the bonds will exceed the principal amount of the bonds.

The consideration offered for each $X principal amount of notes subject to the Tender Offer validly tendered and not withdrawn on or before the Early Tender Date and accepted for purchase will be the Total Consideration, which will be payable on the Settlement Date.

Bondholders of notes subject to the Tender Offer tendering after the Early Tender Date, but on or before the Expiration Date, will only be eligible to receive the Tender Offer Consideration, which will be payable to the such bondholders on the Settlement Date.

Total Consideration offered to bondholders will be calculated using a particular formula.

The Total Consideration payable to bondholders that tender per $X principal of Bonds will equal:

'The present value per $X of principal of all remaining principal and interest payable on the Bonds to maturity, using a discount rate equal to the 'tender offer yield' (the tender offer yield will be yield to maturity of the applicable OS Treasury of comparable tenor security plus the applicable fixed spread) minus

The interest accrued from the last interest payment date to the date of payment of 'Total Consideration'.'

The Tender Offer Consideration payable to bondholders who validly tender after the Early Tender Date is the Total Consideration less a certain amount per $X of principal.

All participating bondholders will also be paid accrued interest on the Bonds from the last payment date to the date of payment of 'Total Consideration' or 'Tender Offer Consideration'.

The borrower will cancel the bonds and the bonds will cease to exist upon repurchase by the borrower.

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 Tender Premium.

Deduction under section 8-1 of the ITAA 1997 in respect of the Tender 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 tender 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 Tender Premium amount is only payable to the bondholders who accept the Tender Offer.

The excess of the total consideration or tender offer consideration paid over the principal on the bonds (the tender premium) is the amount which the taxpayer must pay to compensate bondholders for the early redemption of their bonds.

In addition, the tender premium reflects the price which the taxpayer must pay in order to repurchase the bonds and thereby relieve itself of the burden of paying the above market interest on the 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, the advantage sought by the corporate group in paying the tender premium is that it will be relieved of the obligation to pay the above market interest on the bonds.

The tender premium amount payable is compensation which is akin to a penalty interest payment as described in Taxation Ruling TR 93/7 payable by a borrower to the lender for early repayment of a loan.

Conclusion

Therefore, the tender premium to be paid by the taxpayer to the bondholders is deductible to the taxpayer under section 8-1 of the ITAA 1997.

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.

For the purposes of Division 11A 'interest' is defined in subsection 128A(1AB) of the ITAA 1936 to includes 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, para 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 its 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.

Reference to a principal sum?

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

The definition implies that, in its most basic form, the tender 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 or face value of the principal.

A component of Total Consideration is the tender premium.

It is clear from this formula that both the Total Consideration and Tender Offer Consideration and the tender premium are based on a principal amount.

Tender 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 tender premium amount is only payable to those bondholders who accepted the cash tender offer.

Calculation by reference to time?

Discounted value of the remaining payments is an important component in the tender premium 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 tender premium calculation is made by reference to time.

Conclusion

The tender premium payable to foreign bondholders 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, when the borrower pays the tender premium to foreign bondholders with addresses outside Australia, it 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 of 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.