Edited version of your private ruling

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Ruling

Subject: Group restructure

Issue 1

Question 1

Will the interest expense incurred on borrowings by Company A from an Australian local bank to fund the acquisition of Company B be deductible pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period:

1 September 2011 to 31 August 2012

The scheme commenced:

30 August 2011

Issue 2

Question 1

Will the interest expense incurred on the loan from Company C to Company B be deductible pursuant to section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

1 September 2011 to 31 August 2012

The scheme commenced:

30 August 2011

Issue 3

Question 1

Will the general anti-avoidance provisions of Part IVA of the ITAA 1936 apply to any party in relation to Scheme A (as described below) to preclude tax deductibility of the interest incurred on the funds loaned under this scheme?

Answer

No.

Question 2

Will the general anti-avoidance provisions of Part IVA of the ITAA 1936 apply to any party in relation to Scheme B (as described below) to preclude tax deductibility of the interest incurred on the funds loaned under this scheme?

Answer

No.

This ruling applies for the following period:

1 September 2011 to 31 August 2012

The scheme commenced:

30 August 2011

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.

1. Company C is a foreign resident company which, prior to the implementation of the restructure, directly owned 100% of the ownership interests in both Company A and Company B. The ownership interests in Company A and Company B had been held by Company C since these companies were incorporated.

2. Company B is the manufacturing arm of the group.

3. Company A is the marketing, sales and administrative arm of the group

4. The group has undertaken a restructure of its Australian operations. This restructure has involved the following key steps:

A fully franked dividend was declared and paid by Company B to Company C prior to 1 September 2011. The amount of the dividend was equal to the retained earnings of Company B as at 31 August 2010. The payment of the dividend by Company B to Company C generally accords with the group's current global policy for international subsidiaries which have remitted dividends to the parent company over the last ten years.

A non-secured, interest bearing loan was provided by Company C to Company B in accordance with a loan agreement dated 30 August 2011. The interest payable on the loan is aligned with global transfer pricing arms length principles. This loan was recognised as a non-current liability of Company B in its signed financial statements for the year ended 31 August 2011.

The loaned funds, representing the dividend paid to Company C, are required in Australia as working capital. In particular Company B is expanding its production capacity in Australia. Company B is intending to invest additional money in equipment to expand its business.

On 30 August 2011, Company A entered into a share sale agreement with Company C to acquire all the shares in Company B. In accordance with the share sale agreement the purchase price paid by Company A to Company C for the purchase of the shares in Company B was defined as the net asset position of Company B as at 31 August 2011. It is noted that the sale of shares in Company B occurred after the payment of the dividend from Company B to Company C and the loan back from Company C to Company B. The acquisition of shares in Company B by Company A, which became effective on 1 September 2011, was funded through a loan from a local bank in Australia.

Company A and Company B intend to form a tax consolidated group with effect from 1 September 2011 with Company A being the head entity.

Company B will be liquidated as soon as possible after the formation of the tax consolidated group. The liquidation of Company B is expected to reduce various inefficiencies and costs associated with operating two separate legal entities. The greater operational and management efficiencies are also expected to deliver increased profitability in Australia. Company B's assets will be transferred to Company A on or before the date that Company B is liquidated.

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 Subsection 51(1).

Income Tax Assessment Act 1936 Part IVA.

Does Part IVA, or any other anti-avoidance provision, apply to this ruling?

Part IVA limitation

It is noted that the ruling given in respect of the application of Part IVA of the ITAA 1936 is limited to the deductibility of interest incurred by the relevant parties.

In particular, this private ruling does not consider whether Part IVA of the ITAA 1936 may apply to cancel a tax benefit arising from the restructure or proposed election to form a consolidated group. The Commissioner considers that Part IVA of the ITAA 1936 may potentially apply to cancel any tax benefit arising from the potential restructure or the formation of the tax consolidated group. It is considered that these tax benefits would not have been available if a MEC group had been formed as part of the overall scheme, instead of a consolidated group.

Further issues for you to consider

Transfer Pricing, thin capitalisation and the withholding tax provisions

It is noted that the application of the transfer pricing, the thin capitalisation or the withholding tax provisions have not been considered in relation to the borrowings and interest expense. These provisions may operate to reduce or disallow a proportion of the otherwise deductible interest expense. If you want us to consider these provisions we will first need to obtain and consider all the relevant information.

Reasons for decision

Issue 1 Question 1

Summary

The interest expense incurred on borrowings by Company A from a local bank in Australia to fund the acquisition of Company B is deductible pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

1. In order to obtain an allowable deduction for interest incurred under section 8-1 of the ITAA 1997, a taxpayer must satisfy the conditions in subsection 8-1(1) of the ITAA 1997, and not fall within one of the exceptions in subsection 8-1(2) of the ITAA 1997. That is, the interest expense needs to be either:

(a) incurred in gaining or producing assessable income; or

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

2. Guidance on the eligibility for a deduction for interest on borrowings to fund share acquisitions under section 8-1 of the ITAA 1997 (formerly subsection 51(1) of the ITAA 1936) is contained in Taxation Ruling IT 2606. In particular, paragraph 9 of IT 2606 states:

As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsection 51(1) where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in the short or long term. However, such an expectation must be reasonable and not a mere theoretical possibility; there must be a prospect of dividends or other assessable income being received.

3. However, during the period of consolidation, the single entity rule (SER) in section 701-1 of the ITAA 1997 treats subsidiary members of a consolidated group as parts of the head company rather than as separate entities for income tax purposes. Consequently, all dealings that are solely between members of the same consolidated group are not recognised for income tax purposes. Therefore, as Company A and Company B (prior to its liquidation) are members of the same consolidated group headed by Company A, any dividends payable by Company B to Company A as a return on Company A's share investment in Company B will be treated as a movement of funds between two parts of the same entity (Company A as the head company) rather than the payment of a dividend and as such will not form part of the assessable income of Company A. This interpretation is confirmed in paragraph 10 of Taxation Ruling TR 2004/11 on the meaning and application of the SER.

4. Therefore, the prospect of future dividends, which was the basis for the deductibility of interest on loans to fund share acquisitions in IT 2606 has no application in the present situation with regard to Company A's acquisition of the shares in Company B.

5. Taxation Determination TD 2004/36 deals with the deductibility of interest paid on funds lent interest-free to a subsidiary member of a consolidated group. The principles espoused in this TD are applicable to the present case. Paragraphs 5 to 7 of TD 2004/36 are particularly relevant to the present facts:

5. Where an interest-free, intra-group loan exists between the head company and a subsidiary member of a consolidated group, the prospect of future dividends, which was a rationale for interest deductibility under section 8-1 of the ITAA 1997 accepted in Total Holdings and in IT 2606, cannot be the basis for a deduction for the head company's interest expense.

6. Accordingly, the deductibility of interest paid on the funds on-lent interest-free to the subsidiary member must be determined having regard to the purpose of the borrowing and the use to which the borrowed funds are put by the head company (as the relevant entity and on behalf of the consolidated group).

7. The general principles governing the deductibility of interest are applied to the head company as if it were a single entity. These principles are set out in Taxation Ruling TR 95/25 at paragraphs 2 and 3, with a further explanation for companies provided at paragraphs 12 to 17

6. The requirements that must be met in order for the interest payments to be deductible under section 8-1 of the ITAA 1997 in the present case, apply to Company A (as the relevant entity and on behalf of the consolidated group).

7. TR 95/25 outlines the general principles governing the deductibility of interest under section 8-1 of the ITAA 1997. The relevant paragraphs in TR 95/25 (as amended by Addendum) are reproduced below:

General principles governing deductibility of interest

2. The deductibility of a loss or outgoing comprising interest under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)( formerly subsection 51(1) of the Income Tax Assessment Act 1936) depends upon satisfying the words of the section, that is, being able to show that the loss or outgoing (or the part of the loss or outgoing in an appropriate case of apportionment) is:

(a) incurred by the taxpayer in gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('first limb'); or

(b) necessarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('second limb').

3. The cases clearly indicate that whether or not a loss or outgoing incurred by a taxpayer satisfies the requirements of section 8-1 is dependent on all the facts and matters relating to the loss or outgoing incurred by the taxpayer in question. However, the following general principles are relevant to the question whether interest is deductible under section 8-1:

(a) The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances.

(b) The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. However, regard must be had to all the circumstances, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest.

(c) A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity. Normally this would be the case for non-business taxpayers. It might also be the case where a business makes a specific borrowing which goes to the structure of the business - for example, where a business makes a large borrowing to fund an offshore acquisition.

(d) A rigid tracing of the borrowed money will not always be necessary or appropriate (e.g., where the borrowing finances the replacement of funds withdrawn from the business by a person entitled to be paid those funds). In such cases the relevant question is whether borrowed funds are being used to replace another source of funding for business purposes.

(e) Interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets.

(f) Interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

(g) The interest will not be deductible, to the extent to which it is private or domestic in nature, or is incurred in relation to the gaining or production of exempt income.

8. In the current circumstances, it is considered that by acquiring the shares in Company B, Company A has, under the SER, effectively used the borrowings to acquire Company B's assets and the income streams generated by these assets.

9. Company B's financial statements affirm the income-generating capacity of this entity and its assets historically and the likelihood that such income will be generated in the future which, under the SER, will be taken to be assessable income of Company B.

10. On this basis, it is therefore considered that the interest expense in question has a sufficient connection with the operations or activities which produce Company A's assessable income, which in this case is derived from the Company B's income producing assets.

11. The negative limbs of section 8-1 of the ITAA 1936 are also considered to have no application to this case. In this regard, it is noted that outgoings of interest are a recurrent expense and that the fact that borrowed funds are used to purchase a capital asset does not mean that the interest outgoings are on capital account (see Steele 99 ATC 4242 at 4249; (1999) 41 ATR 139 at 148).

12. Consequently, based on the principles set-out in TR 95/25, Company A will be entitled to a deduction under section 8-1 of the ITAA 1997 for the interest expense incurred on the loan from a local bank in Australia that is used to fund the acquisition of Company B.

13. It is also noted that the proposed liquidation of Company B (after the consolidated group has been formed) will not affect the connection between the interest expense and the production of assessable income and therefore the deductibility of this interest given that the income-producing assets of Company B will remain in the consolidated group.

Issue 2 Question 1

Summary

The interest expense incurred on the loan from Company C to Company B will be deductible pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

1. As previously noted, the general principles governing the deductibility of interest apply to the head company of a consolidated group. These principles are set out in Taxation Ruling TR 95/25 at paragraphs 2 and 3. Paragraphs 12 to 17 of TR 95/25 also provide further guidance on how these principles apply to companies.

2. The deductibility of interest on the funds borrowed must be determined having regard to all the facts (taking account of the effect of the SER in section 701-1 of the ITAA 1997) and considering the connection between the interest expense and the gaining of the head company's assessable income or the carrying on of the head company's business for the purpose of producing assessable income.

3. In assessing whether the interest expense is deductible under section 8-1 of the ITAA 1997, the head company of the consolidated group (Company A) needs to demonstrate that the essential character of the interest is expenditure that has a sufficient connection with the operation or activities which more directly gain or produce the head company's assessable income, provided that expenditure is not of a capital, private or domestic nature.

4. It is relevant to note that, in establishing the existence of the requisite connection by the head company, the entry history rule in section 701-5 of the ITAA 1997 may be of assistance where funds are borrowed by a subsidiary prior to joining a consolidated group. Section 701-5 of the ITAA 1997, which contains the entry history rule, states:

For the head company core purposes in relation to the period after the entity becomes a *subsidiary member of the group, everything that happened in relation to it before it became a subsidiary member is taken to have happened in relation to the *head company.

5. In the current circumstances, the interest expense in question relates to a loan that was originally provided by Company C to Company B. This loan was provided and used by Company B to replenish funds referrable to a dividend paid by Company B.

6. It is considered, based on the circumstances of the loan arrangement and the interest expense in question, that the principles espoused in the Full Federal Court case of FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith) are of relevance. In that case, Hill J stated that the interest on 'a borrowing [by a common law partnership] to fund repayment of moneys originally advanced by a partner and used as partnership capital' will be deductible under subsection 51(1) of the ITAA 1936 to the extent the partnership capital was employed in a business of the partnership which was carried on for the purpose of producing or gaining assessable income (ATC at 4389; ATR at 505).

7. The reasoning, applied by the Full Federal Court in Roberts and Smith is considered to have an equal application to companies which, as highlighted in paragraph 15 of TR 95/25, means that:

…interest on a borrowing by a company is likely to be deductible where the borrowing is used to fund the payment of a declared dividend (including a deemed unfrankable and unrebatable dividend paid from a "tainted share capital account" after 1 July 1998) to the shareholders in circumstances where the funds representing the dividend are employed as capital or working capital in the business carried on by the company for the purpose of deriving assessable income. In circumstances where the liability to pay the dividend reduces the amount to the credit of the unappropriated profits account and the reduction is replaced in the company's accounts by the loan, there will usually be a nexus between the interest expense and the carrying on of a business for the purpose of deriving assessable income.

8. In the current circumstances, the funds loaned by Company B were effectively used to finance the payment of the dividend. It is also accepted, taking into consideration Company B's financial statements, that the funds representing the dividend were employed as capital or working capital in the business carried on by Company B for the purpose of deriving assessable income.

9. Therefore, based on these features, and the application of the entry history rule in section 701-5 of the ITAA 1997, it is considered that sufficient connection exists between the interest expense and the gaining of the head company's assessable income or the carrying on of the head company's business for the purpose of producing assessable income.

10. As the necessary connection exists between the interest expense and the gaining of the head company's assessable income, Company A (as the head company of the consolidated group) will be entitled to a deduction under section 8-1 of the ITAA 1997 for the interest expense incurred on the loan from Company C.

11. It is also considered that the requisite connection between the interest expense and the gaining of Company A's assessable income or the carrying on of Company A's business for the purpose of producing assessable income will be maintained, if as indicated, the loaned funds are used to acquire additional equipment as part of an expansion of Company B's business.

Issue 3 Questions 1 and 2

Summary

Part IVA of the ITAA 1936 will not apply to either Scheme A or Scheme B (as described below) as it is considered that no tax benefit will arise to a relevant taxpayer under either scheme.

Detailed reasoning

1. Part IVA of the ITAA 1936 is a general anti-avoidance provision. Part IVA of the ITAA 1936 gives the Commissioner the discretion to cancel a 'tax benefit' that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA of the ITAA 1936 applies.

2. Generally speaking Part IVA of the ITAA 1936 will only apply to an arrangement where:

· you obtain a tax benefit from a scheme that would not have been available if the scheme had not been entered into, and

· it could be objectively concluded that you had entered the scheme for the sole or dominant purpose of obtaining the tax benefit.

Scheme

3. Scheme is defined in subsection 177A(1) of the ITAA 1936 as:

(a)     any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b)     any scheme, plan, proposal, course of action or course of conduct.

4. The Commissioner may advance alternative schemes including a narrower scheme within a wider scheme in support of a Part IVA determination. In Federal Commissioner of Taxation v. Peabody (1994) 181 CLR 359 at 382; 123 ALR 451 at 459; 94 ATC 4663 at 4670; 28 ATR 344 at 351 the High Court held that although the Commissioner had identified a scheme covering a wide series of transactions, he was also entitled to rely on a narrower part of the scheme.

5. In the current circumstances, two separate and distinct schemes have been considered. These are:

Scheme A: The acquisition of all the shares in Company B by Company A from Company C, with the acquisition being financed through a loan from a local bank in Australia; and

Scheme B: The payment of a fully franked dividend by Company B to Company C and the subsequent provision of an interest bearing loan by Company C to Company B equivalent to the dividend received.

6. It is noted that, for the purposes of this Ruling and the considered application of Part IVA of the ITAA 1936, neither Scheme A nor Scheme B extend to cover the proposed election by Company A to form a consolidated group, effective from 1 September 2011 and any tax benefit that may arise from the same.

Tax benefit

7. Part IVA of the ITAA 1936 cannot apply unless a taxpayer has obtained, or would, but for section 177F obtain, a tax benefit in connection with a scheme. Subsection 177C(1) of the ITAA 1936 defines four kinds of tax benefit, relating broadly to:

(i) an amount not being included in the assessable income of the taxpayer of a year of income;

(ii) a deduction being allowable to the taxpayer in relation to a year of income;

(iii) a capital loss being incurred by the taxpayer during a year of income;

(iv) a foreign tax credit being allowable to the taxpayer.

8. The identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA, of an 'alternative hypothesis' or an 'alternative postulate'. This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out.

9. The reasonable expectation test in subsection 177C(1) of the ITAA 1936 requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable (Federal Commissioner of Taxation v Peabody (1994) 181 CLR 359; 123 ALR 451; 94 ATC 4663; 28 ATR 344).

10. It is noted that when formulating an alternative postulate the Commissioner may, depending on the facts of the case, determine that an element of the scheme may form part of the alternative postulate (Commissioner of Taxation v Ashwick (Qld) No 127 Pty Ltd & Ors [2011] FCAFC 49; 2011 ATC 20-255.)

Scheme A- tax benefit

11. In the current circumstances, as a consequence on Scheme A, Company A is entitled to a tax deduction under section 8-1 of the ITAA 1997 for the interest incurred on the loan from the Australian bank that was used by Company A to acquired all the shares in Company B. This deduction could on face value be considered to be a 'tax benefit' (as described in paragraph 177C(1)(b) of the ITAA 1936) that has been obtained by Company A as a consequence of Scheme A. This conclusion proceeds on the assumption that the acquisition of Company B's shares would not otherwise have occurred but for the scheme.

12. However, based on the facts of this case, it is reasonable to accept that Company A would have acquired the shares in Company B (or its assets) and as such this attribute should be taken into consideration, particularly when examining the alternative postulate.

13. On the basis that Company A would have acquired the shares in Company B, financing would have been required to fund this acquisition. The loan undertaken by Company A is from a local Australian bank and as such the terms of the loan agreement (and specifically the interest imposed) would be expected to be of an arm's length nature. Therefore, even if an alternative means of debt finance were used to acquire the shares in Company B (or it's income producing assets), it would be reasonable to expect that a tax deduction of a similar quantum for interest incurred on the loan would have been available to Company A under this alternative postulate. It is therefore considered that no tax benefit would be obtained by Company A as a consequence of Scheme A.

14. As a tax benefit is not or would not be obtained by Company A as a consequence of Scheme A, the requirements in paragraph 177D(a) of the ITAA 1936 are not met and therefore Part IVA of the ITAA 1936 will not apply. Consequently, the Commissioner will not make a determination under section 177F of the ITAA 1936 to deny Company A interest deductions arising from the loan from the local Australian bank under Scheme A.

15. For completeness, it is noted that as the requirements of paragraph 177D(a) of the ITAA 1936 are not satisfied, it is unnecessary to consider further the additional requirements of section 177D of the ITAA 1936 and in particular the application of paragraph 177D(b) of the ITAA 1936.

Scheme B- tax benefit

16. As a consequence of Scheme B, Company B (and in turn Company A upon the formation of a consolidated group) are entitled to a tax deduction under section 8-1 of the ITAA 1997 for the interest incurred on the loan from Company C that was used to replenish its working capital.

17. The alternative postulate in this case for Scheme B would be that Company B not pay the dividend to Company C and retain such funds for working capital purposes thus avoiding the need for finance.

18. In applying the reasonable expectation test to identify a counterfactual, the following attributes, as noted in paragraph 74 of Practice Statement Law Administration PS LA 2005/24, may be considered:

· the most straightforward and usual way of achieving the commercial and practical outcome of the scheme (disregarding the tax benefit);

· commercial norms, for example, standard industry behaviour;

· social norms, for example, family obligations;

· behaviour of relevant parties before/after the scheme compared with the period of operation of the scheme; and

· the actual cash flow.

19. Based on the facts of this case and specifically taking into consideration Company B's financial performance, its dividend history and the company's policies and practices it is reasonable to accept that any counterfactual would include the payment of the dividend.

20. The taxpayer has stated that the funds loaned by Company B from Company C were required to replenish the company's working capital in Australia and in particular expand Company B's production capacity by purchasing additional plant and equipment. This attribute is also reflected in the terms of the shareholder's loan agreement between Company B and Company C dated 30 August 2011.

21. It would therefore be reasonable to expect that, to the extent of the dividend that was reasonably to expected to be paid, Company B would have required finance to replenish its working capital and fund its expansion plans.

22. As the terms of the loan agreement between Company B and Company C dated 30 August 2011 are of an arm's length nature, it would seem reasonable to conclude that, if Company B had sought an alternative means of debt finance to replenish its working capital/fund its expansion, a tax deduction relating to interest incurred of a similar quantum would have been available to Company B and in turn Company A. As a result, it is considered that no 'tax benefit' would arise for Company B or Company A.

23. As a tax benefit is not or would not be obtained by Company A or Company B as a consequence of Scheme B, Part IVA of the ITAA 1936 will have no application. Consequently the Commissioner will not make a determination under section 177F of the ITAA 1936 to deny Company A or Company B interest deductions associated with the loan from Company C under Scheme B.

24. For completeness, it is noted that as the requirements of paragraph 177D(a) of the ITAA 1936 are not satisfied, it is unnecessary to consider further the additional requirements of section 177D of the ITAA 1936 (and in particular the application of paragraph 177D(b) of the ITAA 1936)