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Ruling

Subject: Income Tax

Question 1

Will entity A be exempt from the thin capitalisation provisions in Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997) due to it falling within the insolvency-remote special purpose entity exemption provided by section 820-39 of that Act?

Answer

No. Entity A is not exempt from the thin capitalisation provisions in Division 820 of the ITAA 1997 under section 820-39 of the ITAA 1997 because it does not satisfy the condition in paragraph (3)(a) of that section.

This ruling applies for the following periods:

Income year ending 30 June 2013

Income year ending 30 June 2014

Income year ending 30 June 2015

Income year ending 30 June 2016

Income year ending 30 June 2017

Income year ending 30 June 2018

Income year ending 30 June 2019

The scheme commences on:

The scheme is proposed to commence during the income year ending 30 June 2013

Relevant facts and circumstances

1. Entity A was specifically established to finance the construction and operation of public infrastructure under a public private partnership.

2. Entity A borrows from a syndicate of lenders and on-lends the entirety of the funds to entity B at the same rate and on the same terms.

3. Entity A is part of a group of resident entities that has recently been acquired by a consortium consisting primarily of foreign investors.

4. Entity A proposes to refinance its existing syndicated facilities, and concurrently restructure its debt, ownership and governance with the purpose of satisfying an international rating agency's criteria for 'insolvency remoteness' so as to minimise long-term credit costs.

5. Under the restructure, entity A will continue to borrow from a syndicate of lenders and on-lend the whole of the funds to entity B at the same rate and on the same terms for the purpose of financing the continued operation of the infrastructure.

Relevant legislative provisions

ITAA 1997 Div 820

ITAA 1997 Subdiv 820-A

ITAA 1997 820-39

ITAA 1997 820-39(1)

ITAA 1997 820-39(3)

ITAA 1997 820-39(3)(a)

ITAA 1997 820-39(3)(b)

ITAA 1997 820-39(3)(c)

ITAA 1997 820-39(4)

ITAA 1997 820-40

ITAA 1997 Subdiv 820-K

ITAA 1997 820-942

ITAA 1997 820-942(2)

ITAA 1997 950-100

ITAA 1997 995-1(1)

Acts Interpretation Act 1901 15AA

Taxation Laws Amendment Act (No 5) 2003

Reasons for decision

Summary

(All legislative references below are to the ITAA 1997 unless otherwise stated. References to 'the EM' are to the Explanatory Memorandum to Taxation Laws Amendment Bill (No. 5) 2003.)

Section 820-39 was introduced into the thin capitalisation provisions in Division 820 by Taxation Laws Amendment Act (No. 5) 2003 in order to remedy deficiencies in the so-called 'zero capital' treatment, which provides a carve-out of certain assets from the thin capitalisation regime permitting full debt funding of those assets. This treatment recognised that securitisation vehicles are tax neutral entities established to pool assets and are generally funded entirely through the issue of debt interests without the need to hold equity.

However, many bona fide securitisation programs were not able to take advantage of the zero-capital treatment: for example, those involving origination, warehousing, two-tiered securitisation or synthetic securitisation, or where the securitisation vehicle had residual equity holdings. The entities engaged in such programs were at risk of having a portion of their debt deductions 'inappropriately' denied under the thin capitalisation provisions.

Section 820-39 was introduced to address this problem by exempting from the thin capitalisation regime for all or part of an income year certain special purpose entities (SPEs) that meet all the conditions laid down within that section.

It is the condition in paragraph 820-39(3)(a), which delineates the type of SPE that may qualify for the exemption that falls for particular consideration in the present case. On its face, the paragraph appears broadly inclusive. However, to determine its breadth requires a proper examination of the legislative context and purpose behind section 820-39 as a whole, utilising established principles of statutory interpretation.

Such considerations lead to the conclusion that paragraph 820-39(3)(a) in fact restricts the types of entities that may take advantage of the exemption to those carrying on activities that are part of a securitisation program. This in turn involves an enquiry into what constitutes 'securitisation'.

Finally, it is considered that the activities that entity A carries on do not constitute securitisation as commonly understood. Accordingly, entity A fails to satisfy the condition in paragraph 820-39(3)(a). Since the conditions in all three of paragraphs (a), (b) and (c) of subsection 820-39(3) need to be satisfied to attract the exemption under section 820-39, entity A does not attract the exemption.

Detailed reasoning

The following reasoning is based on ATO Interpretative Decision ATO ID 2012/31 Thin Capitalisation: exemption - certain special purpose entities.

Subsection 820-39(1) provides that the thin capitalisation rules do not apply to disallow any debt deductions (as defined in section 820-40) of an entity for an income year if the entity meets the conditions in subsection 820-39(3) throughout the income year. The conditions in subsection 820-39(3) are that:

(d) the entity is one established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself); and

(e) the total value of debt interests in the entity is at least 50% of the total value of the entity's assets; and

(f) the entity is an insolvency-remote special purpose entity according to criteria of an internationally recognised rating agency that are applicable to the entity's circumstances.

Considered in isolation, the wording in paragraph 820-39(3)(a) appears capable of a broad interpretation encompassing a wide variety of financing structures. However, when regard is also paid to the legislative context and purpose of the paragraph and section 820-39 as a whole, it becomes apparent that the scope and operation of paragraph 820-39(3)(a) is limited to only those entities that are established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments of a securitisation transaction or structure.

Legislative context

Paragraph 820-39(3)(c) is particularly relevant to the interpretation of paragraph 820-39(3)(a). One of the fundamental tenets of securitisation is the concept of 'insolvency-remoteness'. This concept is specifically associated with securitisation transactions only. Whilst other types of transaction (for example, project financing) may involve an insolvency-remote SPE, insolvency-remoteness is a concept that is not associated with those transactions.

The publications of the international ratings agencies dealing with insolvency-remoteness criteria lend further support to the view that the concept of insolvency-remoteness is inextricably associated with securitisation transactions and structures. See, for example, Standard & Poors' Structured Finance - Guide to Legal Issues in Rating Australian Securitization, published in March 2005 (the Guide).

The first paragraph of the introduction to the Guide contains the following sentence:

This guide describes the key legal issues in rating securitization [sic] in Australia and explains Standard & Poor's approach to those issues. [Italics added]

At the beginning of the section of the Guide entitled 'Insolvency Remoteness: Special-Purpose Entities', is the following sentence:

To achieve "insolvency remoteness" of underlying assets from their originator, and for issued instruments to have the potential to be rated higher than the originator, the benefit of the underlying assets must be transferred to a securitization entity - a special purpose entity (SPE) - in a manner that creates complete legal independence from the originator. [Italics added]

Further contextual support for the view that paragraph 820-39(3)(a) is to be understood within a securitisation context is Note 2 following subsection 820-39(4) and the Note following the definition of 'securitisation vehicle' in subsection 820-942(2).

Note 2 following subsection 820-39(4) states:

An entity that does not qualify for the exemption in this section may still be a securitisation vehicle under subsection 820-942(2), in which case the value of its securitised assets will count towards its zero-capital amount under Subdivision 820-K.

The Note following subsection 820-942(2) states:

An entity that does not qualify as a securitisation vehicle may be exempt from the thin capitalisation rules under section 820-39.

This pair of notes indicates a connection between Subdivision 820-K and section 820-39 and that they have a related purpose within the thin capitalisation regime of jointly capturing all types of vehicles or entities that carry on activities related to securitisation.

The heading to section 820-39, 'Exemption of certain special purpose entities' [italics added] is a further pointer to a restrictive interpretation of what types of SPE are contemplated by the section.

Purpose

The purpose for introducing section 820-39 was to address the somewhat restrictive scope and operation of the definitions of 'securitised asset' and 'securitisation vehicle' in section 820-942. According to the EM, the definitions of 'securitisation vehicle' and 'securitised asset' meant that a variety of bona fide securitisation vehicles and structures would not be able to take advantage of the benefits of the zero capital treatment provided under section 820-942. Paragraphs 1.6 and 1.7 of the EM state the following:

1.6 The securitisation industry is complex and dynamic. Many securitisation programs are not able to avail themselves of the benefits of the zero capital treatment provided under the current thin capitalisation legislation. In particular, the current definitions do not contemplate origination, warehousing, two-tiered securitisation or synthetic securitisation. Nor do the current rules allow any residual equity holding in a securitisation vehicle. As a consequence, many bona fide securitisation vehicles will inappropriately have a proportion of their interest deductions denied under the thin capitalisation rules. [Emphasis added]

1.7 To address this, amendments will exclude special purpose entities from the thin capitalisation rules for all or part of the income year provided that the following conditions are met:

· the entity is established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself);

· at least 50% of the entity's assets are funded by debt interests; and

· the entity is an insolvency remote special purpose entity according to the criteria of an internationally recognised rating agency applicable to the entity's circumstances.

Relevantly, as to the scope and operation of subsection 820-39(3), paragraph 1.14 of the EM states that:

1.14 The three conditions in subsection 820-39(3) seek to cover a broad and ever expanding range of securitisation activity and structures. For example, the conditions seek to include a warehousing type entity where securitised assets are temporarily placed pending their transfer to another entity. The conditions also seek to cover a two tiered securitisation structure where one entity holds the securitised assets and the other entity issues the debt interests (emphasis added).

As the EM makes clear, the purpose of the legislative amendments to the thin capitalisation regime introducing section 820-39 was to expand the range of securitisation activities and structures that can be employed by bona fide securitisation vehicles without being penalised under that regime. The inclusion of the conditions in subsection 820-39(3) were thus intended to cover all securitisation entities that would otherwise not have been caught by section 820-942 including those securitisation entities that create the risk themselves.

The Senate Economics Legislation Committee report into the Provisions of the Taxation Laws Amendment Bill (No. 5) 2003 (the SELC report) echoes the statements made in the EM regarding the scope and purpose of section 820-39. For example, paragraphs 2.16 and 2.21 of the SELC report relevantly states:

2.16 This Bill, will, if passed, exempt certain special purpose entities, in particular, 'securitisation vehicles' from the operation of the thin capitalisation regime.

…

2.21 As explained in the explanatory memorandum, this condition [paragraph 820-39(3)(c)] seeks to ensure that the entity (ie the securitisation vehicle) meets or would meet an internationally recognised rating agency's requirements for an insolvency remote special purpose entity (ie: that the possibility of the entity becoming insolvent is remote). (Emphasis added)

In relation to paragraph 820-39(3)(a) specifically, the EM states the following at paragraph 1.8:

1.8 The first condition is a purpose test that seeks to exclude entities that are not specifically established for what might be commonly referred to as securitisation or origination activity. It also seeks to exclude entities that undertake any activities not related to the process of securitisation or origination. The first item seeks to cover items and risks that could be securitised or originated. For example, it covers a straightforward arrangement where assets are purchased by a special purpose entity. It also covers more complex arrangements, for example, where the risk associated with the assets is acquired by a special purpose entity but the underlying assets remain on the balance sheet of the originating entity.

Whilst the EM refers to securitisation or origination this must be understood in the context that paragraph 820-39(3)(a) excludes entities that undertake any activities not specifically related to the process of securitisation or origination as part of a securitisation program. This is consistent with the syntax, legislative context and policy of section 820-39.

What is a securitisation?

Since section 820-39 generally and paragraph 820-39(3)(a) specifically is intended to apply to and recognise a broad range of securitisation activities performed by securitisation vehicles, it is important to ascertain what a securitisation is as commercially understood in order to ascertain whether the activities of the entity in the current case fall within the scope of paragraph 820-39(3)(a).

Relevantly, for current purposes, the SELC report (on page 7) defines 'securitisation' in its simplest form as:

…a financial institution selling some of its mortgages, mortgage loans or receivables to a special purpose entity. The vehicle acquires the loans using debt raised from third party investors through bonds - hence securitisation - issuing securities to fund the acquisition of those assets. This removes the assets from the financial institution's balance sheet and lowers the cost of the funds.

Securitisation has also been defined by the Reserve Bank of Australia's bi-annual publication, Financial Stability Review, which is available via the RBA's website, www.rba.gov.au. In an article titled, 'Asset Securitisation in Australia', the RBA define asset securitisation as:

Asset securitisation - the process of converting a pool of illiquid assets, such as residential mortgages, into tradeable securities….

In a standard securitisation arrangement, the SPE will usually purchase assets from an originator or arranger. However, in more complex arrangements for example, the entity may acquire or originate assets into a warehouse portfolio for an interim period pending securitisation of those assets. The SPE will then, as part of a securitisation program, transfer the assets from the warehouse into a securitisation portfolio. An essential feature of these arrangements is that assets, which individually are generally illiquid, are placed in a securitisation portfolio to enable the SPE to raise finance by issuing debt securities.

Does entity A satisfy paragraph 820-39(3)(a)?

Entity A was established for the purpose of financing the construction and ongoing operation of the infrastructure. Entity A has borrowed funds from a syndicate of lenders under a financing arrangement and on-lent those funds to entity B on exactly the same terms and conditions as the financing agreement with the syndicate of lenders.

Entity A has not entered into a securitisation arrangement as commonly understood, irrespective of any risk it may have assumed or created under the financing structure. Entity A is not a securitisation entity. Rather, it is a mere conduit, simply borrowing funds and on-lending those funds to entity B.

Accordingly, entity A does not satisfy paragraph 820-39(3)(a) and it will therefore not obtain the benefit of the exclusion from the thin capitalisation rules provided by section 820-39.