Edited version of your written advice

Authorisation Number: 1051398255072

Date of advice: 12 July 2018

Ruling

Subject: Reorganisation

Question 1

Is the promissory note issued by AusCo a debt interest as defined in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the interest on the promissory note be deductible to AustCo under subsection 230-15(2) of the ITAA 1997?

Answer

Not applicable.

Question 3

If yes to question 2, will AustCo get a transfer pricing benefit for the purposes of Subdivision 815-B of the ITAA 1997 in respect of the promissory note?

Answer

Not applicable.

Question 4

If yes to question 2, is all or part of the debt deductions incurred by AustCo in respect of the promissory note disallowed under Division 820 of the ITAA 1997?

Answer

Not applicable.

Question 5

If yes to question 2, will the Commissioner make a determination under paragraph 177F(1)(b) of the Income Tax Assessment Act 1936 (ITAA 1936) to cancel a tax benefit of a kind referred to in paragraph 177C(1)(b) of the ITAA 1936 obtained, or that would but for paragraph 177F(1)(b) of the ITAA 1936 be obtained, by AustCo as a result of issuing the promissory note?

Answer

Not applicable.

Question 6

Will AustCo have an obligation to withhold an amount under section 12-245 of Schedule 1 to the Taxation Administration Act 1953 (TAA) from the interest accrued on the promissory note?

Answer

No.

This ruling applies for the following period:

Year ended 31 December 20xx

The scheme commences on:

Year ended 31 December 20xx

Relevant facts and circumstances

The reorganisation had a number of transactions and these included the following:

● AustCo acquired all of the issued shares in ABC Co from ForeignCo. AustCo issued a promissory note to ForeignCo to satisfy its obligation to pay for the ABC Co shares, and

● ForeignCo assigned the promissory note and it received a consideration for the assignment.

The terms of the promissory note include as follows:

● the entire outstanding amount shall become immediately payable upon written demand by ForeignCo (the Lender), or

● all principal and accrued interest shall be payable in a lump sum on the maturity date.

AustCo did not make a loss from the promissory note by reference to, or by reason of, the interest on the promissory note for the duration the promissory note subsists.

ForeignCo forgave the outstanding accrued but unpaid interest owed by AustCo.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 subsection 177C(1)

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1936 subsection 177F(1)

Income Tax Assessment Act 1997 subsection 230-15(2)

Income Tax Assessment Act 1997 subsection 230-435(1)

Income Tax Assessment Act 1997 Subdivision 815-B

Income Tax Assessment Act 1997 Division 820

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 subsection 974-15(1)

Income Tax Assessment Act 1997 sub section 974-20(1)

Income Tax Assessment Act 1997 section 974-35

Income Tax Assessment Act 1997 section 974-130

Income Tax Assessment Act 1997 section 974-135

Income Tax Assessment Act 1997 subsection 974-160(1)

Income Tax Assessment Act 1997 section 995-1

Taxation Administration Act 1953 Schedule 1 section 12-245

Reasons for decision

All legislative references are to the ITAA 1997 unless indicated otherwise.

Question 1

Is the promissory note issued by AusCo debt interests as defined in Division 974?

Summary

As all the requirements of the debt test are satisfied, the promissory note issued by AusCo is a debt interest pursuant to section 974-20.

Detailed reasoning

Division 974 provides the rules that determine the classification of an interest as either debt or equity for income tax purposes. In particular, it determines the income tax treatment of distributions or returns made in respect of the relevant interest.

Subsection 974-15(1) 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.

The test for a debt interest is contained in subsection 974-20(1). That subsection states:

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

(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.

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.)

These requirements of the debt test in relation to the promissory note, applied at the time the promissory note is issued and come into existence, are discussed below.

(a) Is there a scheme that is a financing arrangement for the entity?

Subsection 995-1(1) defines 'scheme' to mean any arrangement or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. Thus, the issue of the promissory note by AusCo during the period you asked us to rule on, will fall within this definition of a scheme. The scheme is being entered into or undertaken by AusCo to raise finance to fund the acquisition of the ABC Co shares and therefore, the scheme is a financing arrangement for the entity [paragraph 974-130(1)(a)].

(b) Does the entity or a connected entity of the entity, receive, or will receive, a financial benefit or benefits under the scheme?

Subsection 974-160(1) provides in part that:

(1) in this Act:

financial benefit:

(a) means anything of economic value...;

In accordance with the terms of the ABC Co share sale agreement, AusCo acquired the ABC Co shares from ForeignCo by issuing the promissory note to satisfy its obligation to pay the ABC Co share sale purchase price. The financial accommodation provided to AusCo by the issue of the promissory note represents a financial benefit as defined in subsection 974-160(1).

(c) Does the entity or a connected entity of the entity have an effectively non-contingent obligation to provide a financial benefit or benefits to one or more entities after the time when the financial benefit is received?

'Effectively non-contingent obligation' is defined in section 974-135.

Subsection 974-135(1) states:

"There is an effectively non-contingent obligation 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 (see subsections (3), (4) and (6)) to take that action."

Subsection 974-135(3) then provides:

"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."

Considering these legislative requirements, AusCo will have an effectively non-contingent obligation to provide a financial benefit, as AusCo has an effectively non-contingent obligation under the terms, pricing and conditions of the promissory note to repay the principal and accrued interest on maturity or upon written demand by ForeignCo.

(d) Is it substantially more likely than not that the financial benefit provided will at least equal the financial benefit received?

Section 974-35 sets out the manner in which the value of a financial benefit to be provided or received under the scheme is to be calculated.

Paragraph 974-35(1)(a) provides that the value of a financial benefit to be provided or received is to be calculated in nominal terms, if the performance period ends no later than 10 years after the interest arising from the scheme is issued or, in present value terms if the performance period must, or may, end more than 10 years after the interest arising from the scheme is issued.

As the performance period of the promissory note is not longer than 10 years, nominal values will be used to value any effectively non-contingent obligations. Valuing the effectively non-contingent obligations in nominal terms has the result that it is substantially more likely than not that the value of the financial benefits provided by AusCo on maturity will at least be equal to the value of the financial benefits received under the promissory note.

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

The value provided and the value received will not both be nil.

Related schemes

The applicant has not identified any other scheme related to the promissory note.

Other exceptions or modifications

None of the exceptions to the debt test in section 974-25 apply to the promissory note.

No scheme or series of schemes have been identified designed to operate so that the return on the promissory note is to be used to fund (directly or indirectly) a return to another person in circumstances to which subsection 974-80(2) applies.

Conclusion

As all the requirements of the debt test are satisfied (and no exception or modification applies), the promissory note issued by AusCo is a debt interest pursuant to section 974-20.

Question 2

Will the interest on the promissory note be deductible to AustCo under subsection 230-15(2) of the ITAA 1997?

Subsection 230-15(2) provides the general test for deductibility of a loss under Division 230. The deduction will be available to the extent the loss is made in gaining or producing the relevant taxpayer's assessable income or is necessarily made in carrying on a business for that purpose.

Because AusCo did not make a loss from the promissory note by reference to, or by reason of, the interest on the promissory note for the duration the promissory note subsists, the deductibility to AustCo of the interest on the promissory note issued by AusCo does not have to be considered.

Question 3

If yes to question 2, will AustCo get a transfer pricing benefit for the purposes of Subdivision 815-B of the ITAA 1997 in respect of the promissory note?

The object of Subdivision 815-B is to ensure that the amount that is brought to tax in Australia in respect of cross-border commercial and financial relations and conditions between separate legal entities reflects the arm's length contribution (that is, the economic functions performed, assets used and risks assumed) by the Australian operations and the conditions that might be expected to operate between independent entities dealing at arm's length.

Because the answer to question 2 is ‘not applicable’, this question does not have to be considered.

Question 4

If yes to question 2, is all or part of the debt deductions incurred by AustCo in respect of the promissory note disallowed under Division 820 of the ITAA 1997?

The object of Division 820 is to ensure that certain entities do not reduce their tax liabilities by using an excessive amount of debt capital to finance their Australian operations.

Because the answer to question 2 is ‘not applicable’, this question does not have to be considered.

Question 5

If yes to question 2, will the Commissioner make a determination under paragraph 177F(1)(b) of the ITAA 1936 to cancel a tax benefit of a kind referred to in paragraph 177C(1)(b) of the ITAA 1936 obtained, or that would but for paragraph 177F(1)(b) of the ITAA 1936 be obtained, by AustCo as a result of issuing the promissory note?

Part IVA of the ITAA 1936 (Part IVA) is a general anti-avoidance provision. Under subsection 177F(1) of the ITAA 1936, the Commissioner may make a determination 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 applies.

Part IVA cannot apply unless a taxpayer has obtained, or would, but for section 177F of the ITAA 1936 obtain, a tax benefit in connection with a scheme. Paragraph 177C(1)(b) of the ITAA 1936 relevantly includes as a kind of tax benefit, a deduction being allowable to the taxpayer in relation to a year of income.

For schemes entered into or commenced to be carried out on or after 16 November 2012, a tax benefit must be determined with reference to section 177CB of the ITAA 1936.

Because the answer to question 2 is ‘not applicable’, this question does not have to be considered.

Question 6

Will AustCo have an obligation to withhold an amount under section 12-245 of Schedule 1 to the TAA from the interest accrued on the promissory note?

Summary

AustCo will not have an obligation to withhold an amount under section 12-245 of Schedule 1 to the TAA from the interest accrued on the promissory note.

Detailed reasoning

Interest withholding must be applied under the Pay As You Go (PAYG) withholding provisions in section 12-245 of Schedule 1 to the TAA by Australian residents who pay interest to non-residents. For these purposes, the term ‘interest’ has the meaning given to it in Division 11A of Part III of the ITAA 1936.

Interest

Subsection 128A(1AB) of the ITAA 1936 relevantly provides that interest includes an amount:

(a) that is in the nature of interest, or

(b) to the extent that it could reasonably be regarded as having been converted into a form that is in substitution for interest.

Interest payable pursuant to the promissory note would be interest if it is interest in the ordinary sense or interest in the expanded sense as defined in subsection 128A(1A) of the ITAA 1936.

The term ‘interest’ is not otherwise defined by the ITAA 1936. Guidance must be therefore be sought from other sources.

In Steele v FCT 99 ATC 4242 at 4248; (1999) 41 ATR 139, it was stated that “interest is ordinarily a recurrent or periodic payment which secures … the use of borrowed money during the term of the loan” (at 148).

One feature of a loan is the use of funds for a temporary period. Another feature of a loan is the requirement to repay those funds at the end of that period or on demand (see Taxation Ruling TR 2002/16 - Income tax: the taxation consequences for taxpayers issuing certain stapled securities at paragraph 88). Further, a loan requires the existence of a debtor-creditor relationship underpinned by the obligation to repay the principal sum lent (see Taxation Ruling TR 2002/15 - Income tax: deductibility of payments incurred on moneys raised through the issue of perpetual notes at paragraph 61).

The terms of the promissory note exhibit the features identified in TR 2002/16 and also create a debtor-creditor relationship underpinned by the obligation to repay the principal sum lent. The terms of the promissory note indicate that the interest is calculated based on the unpaid principal amount.

Accordingly, the interest payable on the promissory note constitutes interest for the purposes of the withholding tax provisions in Division 11A of the ITAA 1936.

Is there an obligation to withhold an amount from interest under section 12-245 of the TAA?

An amount of interest will be subject to section 12-245 of Schedule 1 to the TAA where the amount of interest has been paid.

Under section 11-5 of Schedule 1 to the TAA, which is headed ‘constructive payment’, an amount is taken to have been paid by one entity to another entity when the first entity applies or deals with the amount in any way on the other’s behalf or as the other directs.

Under the terms of the promissory note, the entire outstanding amount shall become immediately payable upon written demand by the Lender or all principal and accrued interest shall be payable in a lump sum on the maturity date.

There has been no actual payment of any interest under the promissory note and ForeignCo forgave the outstanding accrued but unpaid interest owed by AustCo.

There has not been any constructive payment of any interest under the promissory note. No amount of accrued interest was capitalised (cf. Millar & Anor v. Commissioner of Taxation [2016] FCAFC 94; 2016 ATC 20-578; (2016) 243 FCR 302 per Pagone and Davies JJ). Pursuant to its particular terms, the effective assignment of the promissory note (including of any accrued interest) are not transactions entered into by the debtor, i.e. AustCo (see Olsson v. Dyson (1969) 120 CLR 365 at 388 per Windeyer J and Taxation Determination TD 2006/12 at paragraph 16). Therefore, the assignment did not cause AustCo to apply or deal with any accrued interest on the assigning creditors’ behalf or as directed by those creditors so as to have constructively paid the interest.

As no amount of interest became due for payment and no interest was actually or constructively paid, under the terms of the promissory note and the subsequent assignments of the promissory note, there is no requirement to withhold under section 12-245 of Schedule 1 to the TAA.