Edited version of private ruling

Authorisation Number: 1011765519005

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Ruling

Subject: Income tax treatment of Financial Instrument - debt equity, general deductions and interest withholding tax

Question 1

Is the Financial Instrument a debt interest pursuant to subsection 974-15(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Advice/Answers

No.

Question 2

Is the Financial Instrument an equity interest pursuant to subsection 974-70(1) of the ITAA 1997?

Advice/Answers

No.

Question 3

Will the Issuer be required to withhold an amount from the return it pays to the Holder pursuant to section 12-245 of Schedule 1 of the Taxation Administration Act 1953 (TAA 1953), at the percentage rate pursuant to the Interest Article of the Treaty?

Advice/Answers

Yes.

Issue 4

Question

Subject to the application of Division 820 of the ITAA 1997, will a deduction be allowable to the Issuer under section 8-1 of the ITAA 1997 for the return incurred on the Financial Instrument prior to the date of effect of an election made to have the provisions of Division 230 of the ITAA 1997 for Taxation of Financial Arrangements (TOFA) apply to the Financial Instrument?

Advice/Answers

Yes.

Relevant facts

The Issuer is an Australian Company.

The Holder is a non-resident with an address outside of Australia. The Holder does not have a permanent establishment in Australia for the purposes of the Treaty.

At the relevant date, pursuant to various documents, the Issuer issued a Financial Instrument to the Holder for a sum of money. The Financial Instrument had a term of more than 10 years. The return payable on the Financial Instrument was based on a formula. The return payable was subordinated to Senior Debt. At maturity, the Issuer was required to repay the sum of money to the Holder.

The Issuer is subject to the Taxation of Financial Arrangements (TOFA) rules in Division 230 of the ITAA 1997 due to an election made pursuant to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009.

During the term of the Financial Instrument, the Issuer has paid returns to the Holder in accordance with the formula. The returns have been paid before and after the above-mentioned election took effect.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 128A

Income Tax Assessment Act 1936 Section 128B

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 974-15

Income Tax Assessment Act 1997 Section 974-20

Income Tax Assessment Act 1997 Section 974-35

Income Tax Assessment Act 1997 Section 974-65

Income Tax Assessment Act 1997 Section 974-70

Income Tax Assessment Act 1997 Section 974-75

Income Tax Assessment Act 1997 Section 974-85

Taxation Administration Act 1953 Schedule 1, Section 12-245

Taxation Administration Act 1953 Schedule 1, Section 12-300

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997)
unless otherwise specified

Question 1

'Debt interest' in an entity is defined in subsection 995-1(1) to have the meaning given by Subdivision 974-B.

Subsection 974-15(1) of Subdivision 974-B provides that:

'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) in relation to the entity.'

Subsection 974-20(1) provides that:

'A *scheme satisfies the debt test in this subsection 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

(a) 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

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

The scheme does not need to satisfy paragraph (a) if the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) (interest as a member or stockholder of the company).'

For the purposes of paragraph 974-20(1)(b) and subsections 974-20(2) and (3), a financial benefit provided or received under the scheme is taken into account only if it is one that the relevant entity has an effectively non-contingent obligation to provide (subsection 974-20(4) and section 974-135).

The debt test requirements are discussed below in respect of the Financial Instrument issued by the Issuer to the Holder.

'Scheme' is defined broadly in subsection 995-1(1) to mean any arrangement; or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. The issue of the Financial Instrument by the Issuer constitutes a 'scheme'.

The application of subsection 974-20(1) (the debt test) to the issue of the Financial Instrument as the relevant scheme is discussed below:

· paragraph 974-20(1)(a) - The scheme is a financing arrangement as the issue of the Financial Instrument is undertaken to raise finance for the Issuer (paragraph 974-130(1)(a); see also Taxation Determination TD 2004/83).

· paragraph 974-20(1)(b) - The Financial Instrument was issued for a sum of money. The Issuer therefore received a financial benefit equal to the sum of money [paragraph 974-160(1)(a)].

· paragraph 974-20(1)(c) - 'Effectively non-contingent obligation' (ENCO) is defined in subsection 995-1(1) to have the meaning given by section 974-135. There is an ENCO to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action [subsection 974-135(1)].

An obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity) other than the ability or willingness of that entity or connected entity to meet the obligation [subsection 974-135(3)].

Subsection 974-135(1) permits consideration only of the pricing, terms and conditions of the scheme in determining whether in substance or effect there is a non-contingent obligation: (see Taxation Rulings TR 2008/3 and TR 2010/5).

The Financial Instrument is issued by the Issuer under terms contained in certain agreements.

The terms of one agreement set out the formula for calculating the return payable on the Financial Instrument, when the return is to be paid and restrictions on the payment. The agreement also provides that the Financial Instrument has duration of longer than 10 years and for a sum of money to be paid by the Holder and for the sum of money to be repaid by the Issuer at maturity. Finally, the agreement provides for subordinated of the Financial Instrument to Senior Debt.

The effect of the terms and conditions underpinning the Financial Instrument means that the sum of money must be repaid at maturity and any return payable on the Financial Instrument is contingent on elements of the formula. At the time the Financial Instrument came into existence, it cannot be concluded that the elements of the formula will result in a positive number. Accordingly, the only financial benefit which the Issuer is under an ENCO to provide is repayment of the sum of money at maturity.

· paragraph 974-20(1)(d) - As the performance period for the Issuer's ENCO is more than 10 years [subsection 974-35(3)], the value of a financial benefit received or provided under the Financial Instrument is its value calculated in present value terms [subparagraph 974-35(1)(a)(ii)]. It is not more likely than not that the value of the financial benefit(s) provided will at least equal to the value of the financial benefit(s) received under the Financial Instrument.

Thus, the requirement in paragraph 974-20(1)(d) is not satisfied.

· paragraph 974-20(1)(e) - The value of the financial benefit provided and the value of financial benefit received are not both nil.

The Financial Instrument, when it comes into existence, does not satisfy all of the requirements of the debt test in subsection 974-20(1). Accordingly, the Financial Instrument does not give rise to a debt interest in the Issuer.

The Issuer's guarantee does not alter the above conclusion.

In addition, the Commissioner will not exercise the discretion contained in section 974-65 to treat the Financial Instrument as a debt interest.

Question 2

'Equity interest' in a company is defined in subsection 995-1(1) to have the meaning given by Subdivision 974-C. Subsection 974-70(1) provides that:

'A *scheme gives rise to an equity interest in a company if, when the scheme comes into existence:

(a) the scheme satisfies the equity test in subsection 974-75(1) in relation to the company because of the existence of an interest; and

(b) the interest is not characterised as, and does not form part of a larger interest that is characterised as, a *debt interest in the company, or a *connected entity of the company, under Subdivision 974-B.'

Subsection 974-75(1) provides that:

'A *scheme satisfies the equity test in this subsection in relation to a company if it gives rise to an interest set out in the following table:

Equity interests

Item	Interest
1	An interest in the company as a member or stockholder of the company.
2	An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is in substance or effect *contingent on the economic performance (whether past, current or future) of: (a) the company; or (b) a part of the company's activities; or (c) a *connected entity of the company or a part of the activities of a connected entity of the company. The return may be a return of an amount invested in the interest.
3	An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of: (a) the company; or (b) a *connected entity of the company. The return may be a return of an amount invested in the interest.
4	An interest issued by the company that: (a) gives its holder (or a *connected entity of the holder) a right to be issued with an *equity interest in the company or a *connected entity of the company; or (b) is an *interest that will, or may, convert into an equity interest in the company or a connected entity of the company.

This subsection has effect subject to subsection (2) (requirement for financing arrangement).

As discussed in Question 1, the issue of the Financial Instrument constitutes a scheme for the purposes of Division 974, and the scheme is a financing arrangement for the Issuer.

Having regard to the pricing, terms and conditions of the scheme, items 1, 3 and 4 of the table in subsection 974-75(1) are not satisfied. The requirements of item 2 of the table are discussed below.

Subsection 995-1(1) defines 'contingent on the economic performance' to have the meaning given by section 974-85, which provides that:

'(1) A right, or the amount of a return, is not contingent on the economic performance of an entity, or a part of the entity's activities, merely because the right or return is contingent on:

(a) the ability or willingness of an entity to meet the obligation to satisfy the right to the return; or

(b) the receipts or turnover of the entity or the turnover generated by those activities.

As discussed at Question 1, the terms of one agreement set out the formula for calculating the return payable on the Financial Instrument.

When considering elements of the formula, the elements apply such that the Issuer's obligation to pay the return is not contingent on economic performance (whether past, current or future) of the Issuer, or part of the Issuer's activities pursuant to subsection 974-85(1).

As was concluded at Question 1, there is an ENCO to repay the sum of money for the Financial Instrument at maturity. Accordingly, the repayment of the sum of money is not contingent on the economic performance of the Issuer (whether past, current or future) or a part of the Issuer's activities.

Therefore, item 2 of the table in subsection 974-75(1) is also not satisfied.

Accordingly, the Financial Instrument does not give rise to an equity interest in the Issuer.

Question 3

Section 12-245 of Schedule 1 to the TAA 1953 requires a person to withhold an amount from interest that it pays to an entity where the recipient has an address outside Australia. However, section 12-300 of Schedule 1 to the TAA 1953 limits the amount to be withheld to the withholding tax liability. The note following section 12-300 of Schedule 1 to the TAA 1953 states that Section 128B of the Income Tax Assessment Act 1936 (ITAA 1936) deals with withholding tax liability.

Subject to subsections 128B(6) and (7) of the ITAA 1936, a person is liable under subsection 128B(5) of the ITAA 1936 to withholding tax if they derive income that consists of 'interest' and the requirements of subsections 128B(2) or (2A) of the ITAA 1936 are satisfied in relation to that income. Pursuant to the Treaty the rate of withholding tax payable will be reduced to the percentage of the gross amount of interest.

In Division 11A of Part III of the ITAA 1936, 'interest' is defined in subsection 128A(1AB) of the ITAA 1936. Subsection 128A(1AB) of the ITAA 1936 relevantly provides that interest includes an amount that is in the nature of interest (paragraph 128A(1AB)(a) of the ITAA 1936), or an amount to the extent that it could reasonably be regarded as having being converted into a form that is in substitution for interest (paragraph 128A(1AB)(b) of the ITAA 1936).

Paragraph 128A(1AB)(a): in the nature of interest

The definition of interest for the purposes of Division 11A of the ITAA 1936 includes 'an amount in the nature of interest'. The Courts have construed this phrase as encompassing the ordinary tests for determining whether an amount is interest: see Century Yuasa Batteries Pty Ltd v Federal Commissioner of Taxation (1997) 73 FCR 528, where Cooper J said (at 548):

'In my view, for a payment to fall within the extended definition under s 128A(1) in the context of the withholding tax provisions of ITAA it must have the character of a return or profit to the lender for the use of money advanced to the borrower howsoever calculated or ascertained. For example, the difference between the "extended credit price" and the cash price under consideration in Re Rouse; South Australian Gas Co v Official Receiver, in my opinion would fall within the extended definition in s 128A(1) of the ITAA.'

And later, Cooper J concluded the payments in question were not interest because (at 548):

'They are not calculated by reference to the principal sum advanced and are not in the nature of an additional return or profit to BNI on the money advanced…'

Accordingly, the definition of interest in section 128A of the ITAA 1936 is not broadened by the reference to an amount 'in the nature of interest'.

Paragraph 128A(1AB)(b): to the extent that it could reasonably be regarded as having being converted into a form that is in substitution for interest

The definition of interest for the purposes of Division 11A of the ITAA 1936 is extended by the inclusion of paragraph 128A(1AB)(b) of the ITAA 1936. This paragraph provides that amounts which may not ordinarily be interest, or in the nature of interest, may nevertheless be classified as interest for withholding tax purposes where it is reasonable to regard the amount as having been converted into a form that is in substitution for interest. The Explanatory Memorandum (EM) to Taxation Laws Amendment Bill 1997 which introduced paragraph 128A(1AB)(b) indicates that paragraph 128A(1AB)(b) was introduced for the abundance of caution and that the paragraph is intended to deal with payments made in respect of a loan, where it could possibly be argued the payment is in a form other than interest.

Although some of the tests for characterising the return on the Financial Instrument as interest are satisfied; for example, the sum of money is repayable and the payments are paid as compensation to the Holder for the use of the principle sum, one key test, being that the payments must flow from the principle sum, is not met. On the basis that the returns paid in respect of the Financial Instrument do not flow from the principal, the returns do not satisfy the ordinary meaning of interest.

In the current case, there is a sum of money repayable at maturity of a term in excess of 10 years. The periodic payments while not interest in the ordinary sense are nevertheless compensation for keeping the Holder out of the use and enjoyment of the principal:

· the payments paid under the Financial Instrument are calculated and paid periodically for the period of the loan;

· The terms of the Financial Instrument make it clear that the payments are payable in respect of the Financial Instrument; and

· the amounts are only payable until the term of the Financial Instrument matures.

Given there are no other amounts payable under the Financial Instrument, the payments described as 'interest' are the only compensation paid to the Holder.

On the basis that the return is not a distribution of the Issuer's profit, it is reasonable to conclude that the return is compensation to the Holder for the use of the principal for the term of the Financial Instrument; and it is reasonable to conclude the return is being paid instead of interest. In agreeing to the terms of the Financial Instrument, it is reasonable to conclude that the Holder would have been satisfied that the return would be reasonable compensation for being deprived of the use of the sum of money. Therefore it is reasonable to conclude that the interest which otherwise would have been payable on the Financial Instrument has been converted into another form, i.e. periodic payments during the loan period, which is paid in substitution for interest.

Therefore, the Issuer will be required to withhold an amount from the return it pays to the Holder.

Question 4

The return incurred on the Financial Instrument is calculated in accordance with a formula.

The return on the Financial Instrument will be deductible where either of the positive limbs in subsection 8-1(1) of the ITAA 1997 are satisfied and the Issuer is not specifically precluded from deducting the return by virtue of any of the negative limbs in subsection 8-1(2) of the ITAA 1997.

Subsection 8-1(1) of the ITAA 1997: The positive limbs

A loss or outgoing will satisfy the positive limbs of subsection 8-1(1) of the ITAA 1997 to the extent that the loss or outgoing is either incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

Often there is little scope for the second limb to operate independently of the first limb. In Ronpibon Tin NL v FC of T (1949) 78 CLR 47at 56), the Full High Court of Australia stated that:

'No doubt the expression "in carrying on a business for the purpose of gaining or producing" lays down a test that is different from that implied by the words "in gaining or producing." But these latter words have a very wide operation and will cover almost all the ground occupied by the alternative.' ¹

The deductibility of amounts like interest on a loan is generally determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put; Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613; FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139 (Steele).

For a loan arrangement, the examination of the purpose of the loan and the use to which the borrowed funds are put is not merely a tracing exercise. The majority of the High Court of Australia (Gleeson CJ, Gaudron and Gummow JJ) stated in Steele² that:

'As was explained in Australian National Hotels Ltd v. FC of T, interest is ordinarily a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of the borrowed money during the term of the loan. According to the criteria noted by Dixon J in Sun Newspapers Ltd v. FC of T it is therefore ordinarily a revenue item. This is not to deny the possibility that there may be particular circumstances where it is proper to regard the purpose of interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature. However, in the usual case, of which the present is an example, where interest is a recurrent payment to secure the use for a limited term of loan funds, then it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset.'

The Issuer issued a Financial Instrument to the Holder for a sum of money. The return on the Financial Instrument is payable periodically until the Financial Instrument matures.

The Agreements confirm that the term of the Financial Instrument is for more than 10 years and it cannot mature before that date, unless a default occurs.

In the present case, the following matters are relevant to the consideration of whether the return on the Financial Instrument paid by the Issuer is deductible pursuant to section 8-1 of the ITAA 1997:

· the Issuer is carrying on a business and the funds were borrowed for the purpose of financing its business operations and activities; and

· commencing from December 2010, the business has produced assessable income.

Accordingly, the return on the Financial Instrument will satisfy the positive limbs in subsection 8-1(1) of the ITAA 1997.

Subsection 8-1(2): The negative limbs

In the current case, the relevant negative limb in subsection 8-1(2) of the ITAA 1997 is whether the return is capital, or of a capital nature. The other negative limbs clearly do not apply.

The courts have established a number of principles or tests to be applied in determining whether a loss or outgoing is capital, or of a capital nature (as opposed to being of a revenue nature). In Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337, Dixon J formulated the classic test (at 363):

'There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward…or by making a final provision or payment so as to secure future use or enjoyment.'

The return on the Financial Instrument has a similar character to that of the interest payments as referred to in the quote above in Steele as it is a recurrent payment to secure the use of the sum of money for a limited period.

The return on the Financial Instrument are periodic payments that secure the Issuer the advantage of the use of the sum of money for a limited period. The advantage is not of an enduring nature. It is therefore proper to regard the return on the Financial Instrument as a revenue item.

Therefore, the return on the Financial Instrument paid will not be capital, or of a capital nature and accordingly, will not fall within any of the negative limbs in subsection 8-1(2) of the ITAA 1997.

Therefore, a deduction will be allowable to the Issuer under section 8-1 of the ITAA 1997 for the return on the Financial Instrument.

TOFA Election

The Loan Notes are subject to the provisions in Division 230 of the ITAA 1997 - Taxation of Financial Arrangements (TOFA) as FMG has made a TOFA election - from the date of effect of the election.