Edited version of private ruling

Authorisation Number: 1011667343694

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Ruling

Subject: Repayment of United States Dollar (USD) Notes and Issue of Great British Pound (GBP) Notes

Question 1

Are the GBP Notes debt interests of the tax consolidated group for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

a) Will the GBP Notes constitute 'qualifying securities' under Division 16E of the Income Tax Assessment Act 1936 (ITAA 1936)?

b) Will the interest payable on the GBP Notes be deductible under section 8-1 of the ITAA 1997?

Answer

a) Yes.

b) Yes.

Question 3

a) Are the USD Notes held on capital account by the tax consolidated group?

b) Will an amount be included in the assessable income of the tax consolidated group under (former) Division 3B of the ITAA 1936 as a result of the repayment of the USD Notes?

c) Will sections 104-25 and 104-35 of the ITAA 1997 apply to the tax consolidated group in relation to the repayment of the USD Notes?

Answer

a) Yes.

b) No.

c) No.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commenced in:

2003

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Background

The tax consolidated group is a listed Australian resident public company incorporated in Australia.

The applicant states that although the tax consolidated group operates in the financial services sector, it does not pursue profits by means of the borrowing and on-lending of funds. The only lending of money that individual group companies undertake is within the confines of the wholly-owned group.

The applicant advises that the tax consolidated group's capital structure is managed in a manner consistent with the prudential guidelines applied by APRA.

Issue of USD Notes

The USD Notes were issued by a member of the tax consolidated group several years ago.

The tax consolidated group on behalf of the member had entered into third party cross-currency swaps at the same time to hedge its exposure to USD in respect of the principal and interest payments in respect of the USD Notes and to change the basis of its interest rate exposure.

Between the date that the USD Notes were issued and when they were redeemed, no principal repayments were made.

Between the time when the USD Notes were issued and the date of their redemption several years later - and the time of entry into the cross-currency swaps and the subsequent close out of the cross-currency swaps at the time of repayment of the USD Notes some years later - there was a significant appreciation in the AUD relative to the USD.

Issue of GBP Notes

The GBP Notes were issued by a member ('the Issuer' or 'the Company') of the tax consolidated group to raise the funds to repay the USD Notes. The GBP Notes have a maturity date of more than 10 years.

The proceeds of the GBP Notes were converted to USD and applied in repayment of the USD Notes.

Due to the appreciation of the AUD relative to the USD during the relevant period of time, the tax consolidated group realised a significant foreign exchange reduction in its liability under the USD Notes and a corresponding foreign currency loss in relation to the close out of the cross-currency swaps.

TOFA elections

The tax consolidated group has not elected for Division 230 of the ITAA 1997 to apply to it prior to the default start date of 1 July 2010, and has not elected to have Division 230 apply to its pre-existing financial arrangements.

Assumption

The applicant requests the Commissioner to assume that the issue of the GBP Notes to refinance the USD Notes will not cause it to breach its thin capitalisation safe harbour limit in any year in which the GBP Notes remain on issue.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 974,

Income Tax Assessment Act 1936 Division 16E,

Income Tax Assessment Act 1997 Section 6-5,

Income Tax Assessment Act 1997 Section 8-1,

Income Tax Assessment Act 1936 Former Division 3B of Part 111,

Income Tax Assessment Act 1997 Section 104-25 and

Income Tax Assessment Act 1997 Section 104-35.

Question 1

Detailed reasoning

Application of the debt test to the GBP Notes

A scheme gives rise to a 'debt interest' in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) of the ITAA 1997 in relation to the entity (subsection 974-15(1) of the ITAA 1997).

Under subsection 974-20(1) of the ITAA 1997, a scheme satisfies the debt test in relation to an entity if:

(a) the scheme is a financing arrangement for the entity; and

(b) the entity, or a connected entity of the entity, receives, or will receive, a *financial benefit or benefits under the scheme; and

(c) the entity has, or the entity and a connected entity of the entity each has, an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when:

(i) the financial benefit referred to in paragraph (b) is received if there is only one; or

(ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and

(d) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and

(e) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil.

Each of these conditions and their application to the GBP Notes is addressed below.

(a) The scheme must be a 'financing arrangement' for the entity.

This scheme is a financing arrangement as the issue of the GBP Notes is part of a scheme to raise finance for the tax consolidated group.

(b) The entity receives, or will receive a 'financial benefit' or benefits under the scheme.

Under the GBP Note terms, the Company received a financial benefit under the scheme.

(c) The entity has an 'effectively non-contingent obligation' under the scheme to provide a financial benefit or benefits to one or more entities after the time when the 'financial benefit' referred to in paragraph (b) is received.

Considering the totality of the clauses of the GBP Note terms it is concluded that the Company has an effectively non-contingent obligation to provide a financial benefit (namely, the provision of both the principal and interest on the GBP Notes at Maturity Date), and that this requirement of the debt test is satisfied.

(d) It is substantially more likely than not that the value provided will be at least equal to the value received.

A calculation of the present value of the financial benefits provided and received indicates it is substantially more likely than not that the financial benefits provided will at least equal the value of the financial benefits received, and therefore this condition is satisfied.

(e) The value provided and the value received are not both nil

The value provided and the value received under the scheme are not both nil, and therefore this condition is satisfied.

Conclusion

As all the requirements of the debt test are satisfied, the GBP Notes will give rise to a debt interest. As a consequence there is no need to consider the application of the equity test in light of paragraph 974-70(1)(b) and subsection 974-5(4) of the ITAA 1997.

Thus, the GBP Notes pass the debt test and are debt interests. However, because the Issuer is part of the tax consolidated group, the head company will be regarded as having issued the GBP Notes by virtue of the single entity rule in section 701-1 of the ITAA 1997.

Question 2

Detailed reasoning

a) Will the GBP Notes constitute 'qualifying securities' under Division 16E of the ITAA 1936?

Division 16E of the ITAA 1936 allows deductions in relation to certain 'qualifying securities' to be claimed on an accruals basis throughout the term of the security, regardless of whether there is an actual payment of such a return.

In order for Division 16E of the ITAA 1936 to apply to the interest payable on the GBP Notes, the Notes must satisfy the definition of a 'qualifying security'. In accordance with subsection 159GP(1) of Division 16E of the ITAA 1936, a qualifying security means any 'security':

(a) that is issued after 16 December 1984;

(b) that is not a prescribed security within the meaning of section 26C;

(ba) that is not part of an exempt series (see subsection 159GP(9A);

(c) the term of which, ascertained as at the time of issue of the security will, or is reasonably likely to, exceed 1 year;

(d) that has an eligible return; and

(e)  where the precise amount of the eligible return is able to be ascertained at the time of issue of the security - in relation to which the amount of the eligible return is greater than 1½% of the amount ascertained by multiplying the amount of the payment or the sum of the payments (excluding any periodic interest) liable to be made under the security by the number (including any fraction) of years in the term of the security;

but does not, except as provided by subsection (10), include an annuity.

The GBP Notes are securities as they satisfy paragraph (c) of the meaning of 'security' in subsection 159GP(1).

The Notes also satisfy each of the conditions of a 'qualifying security' for the purposes of Division 16E as set out in subsection 159GP(1) of the ITAA 1936.

(a) The GBP Notes were issued after 16 December 1984.

(b) The Notes do not satisfy the meaning of 'prescribed security' in subsection 26C(4) of the ITAA 1936.

(ba) As no member of the tax consolidated group has previously issued a security with exactly the same payment dates, payment amounts and other terms as the GBP Notes, the GBP Notes are not 'part of an exempt series' under subsection 159GP(9A) of the ITAA 1936.

(c) The Notes have a term which is reasonably likely to exceed 1 year. Although the GBP Notes are subject to early redemption by the Issuer, such early redemption is subject to gaining written approval from APRA, which cannot be presumed will be granted.

(d) The GBP Notes have an 'eligible return'. As the Issuer may, at the time of issue of the GBP Notes at its option defer payment of interest for a period in excess of one year, it cannot be said that there are amounts of interest payable under the terms of the Notes that meet the definition of 'periodic interest' in subsection 159GP(6) of the ITAA 1936. The Commissioner is satisfied that, at the time the security was issued, it was reasonably likely, by reason that the security bears deferred interest, that the sum of all payments (other than 'periodic interest' payments) under the security would exceed its issue price and that it has an eligible return.

(e) As the yield on the GBP Notes is variable the precise amount of the eligible return is not able to be ascertained at the time of issue of the security.

The GBP Notes are not considered by the Commissioner to be 'annuities'.

Conclusion

The GBP Notes satisfy all of the conditions of a 'qualifying security' set out in subsection 159GP(1) of the ITAA 1936 and constitute qualifying securities.

b) Will the interest payable on the GBP Notes be deductible under section 8-1 of the ITAA 1997?

An amount of interest payable is deductible under paragraph 8-1(1)(a) of the ITAA 1997 to the extent it is incurred in gaining or producing assessable income.

No deduction for interest payable is allowed under subsection 8-1(2) of the ITAA 1997 if:

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

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

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

(d) a provision of this Act prevents it being deductible.

In respect of subsection 8-1(2), as the interest payments are not incurred in gaining or producing exempt income or non-assessable non-exempt income; are not of a private or domestic nature; and because there is no other provision of the ITAA to prevent deductibility of the interest payments, only paragraph (a) will be considered.

Paragraphs 7 and 8 of Taxation Ruling TR 94/26 - Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance, discuss the criteria to be met to satisfy subsection 8-1(1) as follows:

7. In our opinion there are certain cases in which three criteria must be met before an expense satisfies either limb of subsection 8-1(1):

(a)  as previously stated, there is a presently existing liability (called the jurisprudential approach by the High Court in Coles Myer Finance );

(b)  the loss or outgoing which arises as a consequence of that liability is of a revenue character; and

(c)  all or part of the loss or outgoing is properly referable to the particular year in question.

8. It will be necessary to satisfy these three criteria in all cases involving:

(a)   financing transactions; or

(b)  a liability accruing daily; or

(c)   a liability accruing periodically

As the deductibility of the GBP Notes is considered to fall under paragraph 8, it is proposed to consider the three criteria in paragraph 7:

Presently existing liability

Generally speaking, the courts have held that a loss or outgoing is incurred in the year in which a taxpayer comes under a presently existing liability to pay a pecuniary sum. That is, the loss or outgoing must be a presently existing pecuniary obligation that has become due irrespective of whether it is payable now or in the future: F C of T v. James Flood Pty Limited (1953) 88 CLR 492 at 506; Nilsen Development Laboratories Pty Limited & Ors v. F C of T 81 ATC 4031 at 4034-7; (1981) 11 ATR 505 at 508-12; FC of T v. Australian Guarantee Corporation (AGC) 84 ATC 4642 ATC 4658. This does not mean that there must be an actual disbursement of money. It is sufficient if the presently existing liability is due though payable in a future year (Nilsen Development Laboratories; FC of T v. James Flood Pty Ltd (1953) 88 CLR 492).

The interest payable by the Issuer in respect of the GBP Notes accrues daily and becomes a presently existing liability of the Issuer on the Interest Payment Dates.

Properly referable

However, it is not enough to establish the existence of a loss or outgoing actually incurred. It must be a loss or outgoing of a revenue character and it must be 'properly referable', 'properly attributable' or 'fairly referable' to the relevant year of income (cf. Coles Myer Finance 93 ATC 4220 at 4221, ATR 104; New Zealand Flax Investments Ltd v. F C of T (New Zealand Flax) (1938) 61 CLR 179 at 207; AGC 84 ATC 4642 at 4650).

As the interest payable by the Issuer on the GBP Notes accrues daily and becomes a presently existing liability on the Interest Payment Dates, it will be properly referable in the year in which it has been put to profitable advantage; this is the time when the interest is incurred and when it accrues under the GBP Note terms.

Revenue character of the interest expense

Taxation Ruling TR 2004/4 - Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities, considers the implications of the decision of the High Court in Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139 (Steele) in which the Court examined whether interest payable on a loan should be regarded as capital in nature.

Following the reasoning in TR 2004/4, the Commissioner takes the view that the interest payments on the GBP Notes are of a revenue nature.

Additional considerations since the release of TR 2004/4 - interest as a loss or outgoing of a capital nature

In St George Bank Limited v FCT (2009) 73 ATR 148 (St George), the Full Federal Court decided that the payment of interest made in respect of debentures issued to raise Tier 1 capital had the objective of achieving a structural advantage, being the raising of capital to comply with the RBA's requirements (which was a mandatory condition of the taxpayer's banking licence). Compliance by the taxpayer with the RBA's capital adequacy requirements had the immediate effect of improving its ability to withstand losses. That ability went to the heart of the taxpayer's business as a bank, namely, its continued ability to maintain the confidence of its depositors. It also had the superadded effect of allowing the taxpayer to expand its operations where, but for the capital raising, it would be prohibited from incurring further debts to make loans. Since the predominant purpose underpinning the interest was the securing of this structural advantage, it was of a capital nature on the basis of the test in Sun Newspapers Ltd v FC of T (1938) 61 CLR 337 at 361 per Dixon J.

It is considered that the facts of the borrowing and payment of interest under the GBP Notes are distinguishable from the facts in St George, and having weighed of all the relevant factors, the Commissioner is satisfied the interest payments under the GBP Notes are not of a capital nature.

Are the interest payments on the GBP Notes incurred in gaining or producing assessable income as required under paragraph 8-1(1)(a) of the ITAA 1997?

Taxation Ruling TR 95/25 - Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith outlines the implications flowing from the decision of the Full Federal Court in FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith) for entities including companies concerning the deductibility of interest on a borrowing used to refinance funds previously invested in a business.

At the time of repayment of the USD Notes and refinancing through the issue of the GBP Notes, the borrowings were being used in the income producing business of the tax consolidated group; the proceeds of the GBP Notes are also currently being employed in the business of the tax consolidated group.

Applying the principles from Roberts and Smith and the Commissioner's view in TR 95/25, the interest payable on the GBP Notes is considered to be incurred in gaining and producing assessable income.

Conclusion

The interest payable on the GBP Notes is deductible to the tax consolidated group under section 8-1 of the ITAA 1997.

Question 3

Detailed reasoning

a) Are the USD Notes held on capital account by the tax consolidated group?

Division 775 of the ITAA 1997 will not apply in these circumstances.

Where Division 775 of the ITAA 1997 does not apply, the tax treatment of a currency exchange gain or loss will depend on whether the gain or loss is of a capital or revenue nature. The tax treatment of these gains and losses can be summarised as follows:

§ If the gain or loss is of a revenue nature, a gain will be assessable as ordinary income under section 6-5 of the ITAA 1997 while a loss will be an allowable deductible under section 8-1 of the ITAA 1997.

§ If the gain or loss is of a capital nature, it may be assessable or deductible, respectively, under Division 3B of Part III of the ITAA 1936.

§ If the gain or loss is of a capital nature and is not assessable or deductible under Division 3B, it may be dealt with by the capital gains tax rules in Parts 3-1 and 3-3 of the ITAA 1997.

Characterisation of the USD Notes

Because the single entity rule applies one must consider if the USD Notes were on capital account or revenue account from the perspective of the head company.

The characterisation of a foreign exchange gain or loss on the repayment of an amount denominated in a foreign currency will follow the characterisation of the borrowings.

The Company is neither a finance company nor carrying on a money-lending business, and does not pursue profits by borrowing and on-lending funds.

It is considered in this case that the proceeds from the issue of the USD Notes were capital in nature and that the proceeds were used to discharge a loan and not to make a profit by on-lending.

Conclusion

The borrowings under the USD Notes were held on capital account.

b) Will an amount be included in the assessable income of the tax consolidated group under (former) Division 3B of the ITAA 1936 as a result of the repayment of the USD Notes?

Division 3B of the ITAA 1936 may apply if the currency exchange gains or losses which have arisen from the transactions under consideration are capital in nature.

Division 3B of the ITAA 1936 was repealed on 17 December 2003. However, it continues to apply in relation to eligible contracts entered into before 1 July 2003 unless a transitional election is made by the taxpayer under section 775-150 of the ITAA 1997. The tax consolidated group has not made an election under section 775-150. Accordingly Division 3B continues to apply.

A currency exchange gain is taken to have been made, or a currency exchange loss is taken to have been incurred, when it is realised.

Division 3B of the ITAA 1936 will also only apply to a loss incurred by a taxpayer to the extent to which, if the loss were not of a capital nature, a deduction would be allowable under section 8-1 of the ITAA 1997.

The USD Notes

As discussed above, the purpose of the borrowings was capital in nature.

The character of the foreign exchange gain or loss follows the character of the borrowings. Because the borrowings were capital in nature the foreign exchange gains or losses were also capital in nature.

The USD Notes were eligible contracts but were not a 'hedging contract', as defined in paragraph b of the definition of 'eligible contract' in subsection 82V(1) of the ITAA 1936.

Conclusion

The USD Notes were denominated in USD and were redeemed in USD. They met the definition of an 'eligible contract' in subsection 82V(1) of the ITAA 1936 but did not require conversion of the USD to AUD or to any other currency. Applying the reasoning in The Federal Commissioner of Taxation v Energy Resources of Australia (1996) 185 CLR 66 decision, because the unit of account and the unit of payment under the USD Notes were in USD, the tax consolidated group did not realise a gain or loss under the USD Notes which is 'attributable to currency exchange rate fluctuations'.

An amount will not be included in the assessable income of the tax consolidated group under (former) Division 3B of the ITAA 1936 as a result of the repayment of the USD Notes.

c) Will sections 104-25 and 104-35 of the ITAA 1997 apply to the tax consolidated group in relation to the repayment of the USD Notes?

The repayment of the USD Notes to the US Noteholders constitutes the repayment of a debt, or liability.

Under paragraph 52 of Taxation Ruling TR 96/23 - Income tax: capital gains: implications of a guarantee to pay a debt, a borrower is not considered to own or dispose of an 'asset' for CGT purposes as a result of the creation of an interest in a debt.

Butterworths Encyclopaedic Australian Legal Dictionary (Online Edition), LexisNexis Australia defines a loan as:

the temporary transfer of an asset, usually funds, from a lender who controls funds, to a borrower in return for payment, usually in the form of interest. The asset must be returned either in one sum at the maturity of the loan or in periodic payments.

Thus, a liability arises for a debtor when the debtor borrows money under a loan contract. In this case, the tax consolidated group did not acquire a CGT asset but instead incurred a legal obligation, or liability, to repay the funds under the terms of the loan agreement.

Conclusion

Neither sections 104-25 and 104-35 of the ITAA 1997 apply in relation to the repayment of the USD Notes.