Edited version of private advice

Authorisation Number: 1051723901789

Date of advice: 23 July 2020

Ruling

Subject: Return of capital

Question 1

Are the Shareholder Loans provided to AusCo by AusCo shareholders under the Shareholder Loan Agreement entered into between AusCo and its shareholders debt interests under subsection 974-15(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will interest expenses incurred by AusCo under the Shareholder Loans be deductible to AusCo under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 3

Will subsection 45B(3) and section 45C of the Income Tax Assessment Act 1936 (ITAA 1936) apply in relation to the whole, or a part, of the capital payment received by the AusCo shareholders under the return of capital to be paid by AusCo?

Answer

No.

Question 4

Will the return of capital to be paid by AusCo or the crediting of the proceeds of the Shareholder Loans to AusCo's accounts taint the share capital account of AusCo under Division 197 of the ITAA 1997?

Answer

No.

Question 5

Will AusCo be considered a 'foreign controlled Australian company' for the purposes of the thin capitalisation rules under section 820-785 of the ITAA 1997?

Answer

No.

Question 6

Is AusCo considered an 'outward investing entity (non-ADI)' under subsection 820-85(2) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

XX/XX/20XX

Relevant facts and circumstances

AusCo

1. AusCo is the head company of the AusCo income tax consolidated group.
2. AusCo is owned by three shareholders who own the following percentage of shares in AusCo:
   1. ACo - X%
   2. NR Co X% and
   3. BCo - X%

(together, the Consortium)

3. Prior to the acquisition of OpCo by AusCo, ACo and BCo held X% of the shares in OpCo.
4. NR Co is a non-resident company for Australian income tax purposes and did not hold an interest in OpCo prior to its acquisition by AusCo.

OpCo

5. OpCo operates in the service industry. Its key assets are primarily intangible assets.

Acquisition of OpCo by AusCo

6. The former OpCo shareholders were looking to continue to grow the business. OpCo shareholders passed a unanimous resolution for OpCo to pursue a liquidity event for shareholders. This was to be conducted either by way of an initial public offering (IPO) or via a trade sale.
7. AusCo submitted a proposal to purchase OpCo. Due to difficulties around the sale structure, the acquisition of OpCo was entirely equity funded.
8. AusCo acquired 100% of the issued shares in OpCo on XX/XX/XXXX for approximately $X. The acquisition was paid for with a mix of cash and scrip.
9. The cash component of the acquisition was entirely equity funded, with the Consortium members providing share capital contributions to AusCo sufficient to acquire all of the shares in OpCo. OpCo shareholders were paid cash for their shares unless they were Consortium members, who instead received shares in AusCo as consideration for their OpCo shares.

Proposed return of capital and introduction of shareholder debt

10. AusCo intends to return $X of share capital to its shareholders, which will be funded by the injection of shareholder debt into AusCo.
11. The return of capital will be a proportional return per AusCo share on issue, and none of the existing shares in AusCo will be bought back or cancelled. The return of capital will be an equal reduction as described in section 256B of the Corporations Act 2001 (Corporations Act), and approved by shareholders under section 256C of the Corporations Act.
12. The injection of debt into AusCo will be by way of shareholder loans (the Shareholder Loans). The Shareholder Loans will be made by the Consortium members in proportion to their shareholding in AusCo. The Shareholder Loans will be provided on the terms specified in the Shareholder Loan Agreement.
13. The journal entries in the accounts of AusCo to effect the return of capital will be

DR Share capital $X

CR Shareholder loan $X

14. The reasons provided for replacing the contributed capital with shareholder debt are as follows:
    1. The cheaper cost of debt as compared to equity, which in turn lowers the overall weighted average cost of capital
    2. The intent of the parties was always to partially fund the investment with debt and this will allow access to equity contributed, and
    3. It will make it easier to secure third party debt finance as planned by using that finance to replace already established shareholder finance on comparative terms.
15. AusCo and the Consortium members will enter into the Shareholder Loan Agreement.
16. The summarised terms of the Shareholder Loan Agreement entered into on [XX/XX/20XX] are as follows:
    1. Term - 6 years
    2. Principal amount - $X
    3. Use of funds -the proceeds of the Shareholder Loans must be used to fund the return of capital to AusCo shareholders. It is to be utilised by AusCo by way of a single advance equal to the amount of the facility.
    4. Each lender's obligations under the Shareholder Loan Agreement are several. The rights of each lender arising in relation to the Shareholder Loan Agreement are separate and independent rights and any debt arising under the Shareholder Loan Agreement to a lender from AusCo is a separate and independent debt in respect of which each lender shall be entitled to separately enforce its rights.
    5. Each lender's individual participation in the Shareholder Loans is as follows:

                                              i.    BCo $X

                                             ii.    ACo $X

                                            iii.    NR Co - $X

    6. Interest rate - X% p.a.
    7. Interest

                                              i.    Interest accrues daily and is due and payable to the lenders quarterly.

                                             ii.    At a minimum, a cash payment of interest will always be paid to the non-resident shareholder to cover the withholding tax liability that arises on the derivation of interest.

                                            iii.    Any remaining cash payments will be subject to Clause 15, which details a cash flow formula that is used to determine the amount of cash to be paid to the lenders to meet the interest payment falling due.

                                           iv.    Any amount not paid will be capitalised to the loan principal and is due and payable by the end of the loan term.

                                             v.    Any cash-flow under Clause 15 in excess of the interest paid shall be used to prepay the Loan pro rata to each Lender's participation.

    8. Event of default on interest - if AusCo fails to pay any amount payable under the Shareholder Loan Agreement on its due date, in addition to a continuing liability to pay the amount unpaid, AusCo must pay interest on the overdue amount, which will accrue daily from the due date up to the date of actual payment at a rate which is the sum of the interest rate and X% p.a. or the rate payable under any judgment under which the liability to pay the amount is merged. Events of default include

                                              i.    A failure to pay on the due date any sum in the Shareholder Loan Agreement

                                             ii.    A failure to comply with a term or condition under the Shareholder Loan Agreement

                                            iii.    AusCo ceasing to carry on its business or a substantial part of its business, is presumed or deemed to be insolvent, or is in financial difficulty; or

                                           iv.    Any expropriation or process similar executed by a government agency that affects the assets of AusCo.

    9. Prepayment - AusCo may prepay all or any part of the Shareholder Loan together with all interest accrued up to the date of prepayment. Any prepayment of loan principal must be made on a pro-rata basis to all lenders.
    10. Repayment - The Shareholder Loan, together with all accrued interest and all other amounts accrued or outstanding under the Shareholder Loan, must be repaid or paid by AusCo in full on the Repayment Date. No amount repaid or prepaid may be re-borrowed. The Repayment Date is 6 years from the date the Shareholder Loans are advanced.

17. The rights and obligations under the Shareholder Loan Agreement are not contingent on the ownership of a proportionate number of shares in AusCo.
18. AusCo will only be provided debt funding by the Shareholders to the extent it is commercially sustainable, is on arm's length terms, and is within the safe harbour rules in the thin capitalisation regime.

Replacement of shareholder debt with third party debt

19. Within a certain timeframe, AusCo intends to completely replace the Shareholder Loans with third party, interest-bearing debt. This will depend on the performance of AusCo. This will free up working capital that has been contributed to AusCo by the Consortium members.

AusCo Board and Shareholder Deed

20. The AusCo Board comprises X directors, including X shareholder nominee directors.
21. The AusCo Shareholder's Deed reserves a number of matters that require the unanimous approval of shareholder nominee directors, as well as a number of matters that require unanimous shareholder consent. Relevantly, such matters include, but are not limited to:
    1. The entering into, termination, amendment or variation of any contract outside the ordinary course of the business
    2. Appoint, dissolve or alter the composition of any committee of the board
    3. Declare, make or pay any distribution otherwise than in accordance with the Distributions policy
    4. Appointment of the CFO, or approval or variation of any management delegations
    5. Appointment of CEO, Auditor
    6. Amendment to the Constitution of AusCo
    7. Winding up of the Group
    8. Related party transactions
    9. Issue of securities in a company group member or the company which is not pro rata between the current shareholders
    10. Borrowings
    11. Annual budget and business plan
    12. Changes in nature of the business, and
    13. Changes to the share capital or rights attaching to any class of securities in a company group member, other than:

                                          i.    A pro rata entitlement offer, or

                                         ii.    Any change to the capital structure of the Company which relates to, or is in connection with, any pro-rata distribution in accordance with the Distribution Policy.

Other facts

22. AusCo's shareholder equity consists of an issued capital account, retained earnings account and current year earnings. The issued capital account has not had any amounts credited to it other than share capital.
23. Prior to the return of capital, AusCo and OpCo's share capital accounts are not tainted within the meaning of Division 197 of the ITAA 1997.
24. To date, AusCo and OpCo have not paid any dividends to their shareholders.
25. AusCo and OpCo both have significant retained losses and only small current year earnings.
26. BCo is an outward investing Authorised Deposit Taking Institution (ADI) for the purposes of the thin capitalisation rules in Division 820 of the ITAA 1997.
27. But for the relationships that arise as a result of their joint investment in AusCo, the shareholders of AusCo are not associates of one another as defined in section 318 of the ITAA 1936 or section 820-905 of the ITAA 1997.
28. AusCo does not have any shares in any entities that are not residents of Australia.
29. The market value of AusCo's non-taxable Australian assets greatly exceed the value of its taxable Australian real property assets. AusCo shares are not taxable Australian property under section 855-25 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 197-5

Income Tax Assessment Act 1997 section 197-50

Income Tax Assessment Act 1997 Division 820

Income Tax Assessment Act 1997 section 820-85

Income Tax Assessment Act 1997 section 820-785

Income Tax Assessment Act 1997 section 820-905

Income Tax Assessment Act 1997 Division 974

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 974-40

Income Tax Assessment Act 1997 section 974-60

Income Tax Assessment Act 1997 section 974-70

Income Tax Assessment Act 1997 section 974-75

Income Tax Assessment Act 1997 section 974-80

Income Tax Assessment Act 1997 section 974-85

Income Tax Assessment Act 1997 section 974-130

Income Tax Assessment Act 1997 section 974-135

Income Tax Assessment Act 1997 section 974-155

Income Tax Assessment Act 1997 section 974-80

Income Tax Assessment Act 1997 section 974-80

Income Tax Assessment Act 1997 section 974-80

Income Tax Assessment Act 1997 section 975-300

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 section 45C

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 section 318

Reasons for decision

Question 1

Are the Shareholder Loans provided to AusCo by AusCo shareholders under the Shareholder Loan Agreement entered into between AusCo and its shareholders debt interests under subsection 974-15(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The loans provided under the Shareholder Loan Agreement to AusCo are debt interests for the purposes of Division 974 of the ITAA 1997.

Detailed reasoning

The object of Division 974 of the ITAA 1997 is to provide rules to determine whether various instruments are equity or debt for income tax purposes, irrespective of their legal form. The tests in Division 974 of the ITAA 1997 are intended to test the economic substance of the transaction or instrument in making this determination. The tax effects that generally flow from such a finding are that distributions on debt instruments will be deductible but unfrankable, and distributions on equity instruments will not deductible but frankable.

The Shareholder Loans to AusCo are provided under a single Shareholder Loan Agreement, but each shareholder's loan under the Shareholder Loan Agreement is several. They are, therefore, separate interests for the purpose of the debt-equity rules. That being said, barring the amounts of principal, all other aspects of the schemes are identical. As such, the below analysis applies equally to each shareholder loan made to AusCo under the Shareholder Loan Agreement.

The equity test will be considered first, as within it, consideration of the debt test is required.

Equity interest

Subsection 974-70(11) of the ITAA 1997 states that a scheme gives rise to an equity interest in a company if, when the scheme comes into existence;

(a)  The scheme satisfied the equity test in subsection 974-75(1) of the ITAA 1997 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 of the ITAA 1997.

Equity test

Subsection 974-75(1) of the ITAA 1997 states that a scheme satisfies the equity test if it gives rise to an interest set out in the table in that subsection:

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 aspects of economic performance 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 either the right itself, or the amount of the return, is at the discretion of the company. The return may be a return of an amount invested in the interest.
4. An interest issued by the company that gives its holder a right to be issued an equity interest in the company or that will, or may convert into an equity interest.

The Shareholder Loans are not shares in the company, nor are they convertible into a different instrument. As such, it is only items 2 and 3 of the table which require further consideration. Items 2 and 3 also clarify that the return of the investment 'principal' constitutes part of the return for those items.

Subsection 974-85(1) of the ITAA 1997 explains that a right or the amount of a return, is contingent on aspects of economic performance if the right or return is contingent on the economic performance of that activity, but not solely because of one of the following:

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

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

The latter test in this subsection refers to items such as shopping centre rentals, where the rent that constitutes part of the return of the relevant arrangement is often contingent on turnover.

The Shareholder Loans give rise to a return on investment of X% p.a., which accrues daily and is paid quarterly. The interest is able to be capitalised quarterly to the loan principal, with cash paid to cover any interest withholding tax liabilities of the lenders. As such, a fixed return is paid from the company that is due and payable to the lenders, irrespective of AusCo's economic performance or profitability. In the event of default, the lenders are able to take enforcement action to recover the debt, including charging a higher level of interest on outstanding debt.

Economic performance is not defined, but the nature of the test is that the return is contingent or related in some way to the company's profits. The phrase 'ability or willingness' is undefined, but generally refers to situations of capability. For example, where the borrower faces significant financial difficulty or is in conflict with the lender, such situations would not be taken to be circumstances where the return was contingent on aspects of economic performance. The inability to pay in such circumstances does not constitute a payment dependent on economic performance for the purposes of Division 974 of the ITAA 1997.

Based upon its terms, the interest payable under the Shareholder Loan Agreement constitutes a return on the investment that is not contingent on economic performance in the ordinary use of the term.

The repayment of principal to lenders under the Shareholder Loan Agreement is due in X years. However, it may be paid off before this date at the discretion of AusCo. The ability of AusCo to repay the loan principal will be dependent on its economic performance, and the degree to which third party debt has been accessed in the future. However, this repayment of the principal is guaranteed, irrespective of economic performance. The complete repayment of principal is required within X years from the date the facility is provided, regardless of AusCo's performance. As such, it also constitutes a return not contingent on economic performance.

With respect to item 3 in the table, the payments of both interest and principal under the Shareholder Loan Agreement are not subject to the discretion of the company. Irrespective of whether the company chooses to pay the interest in cash at the time it arises or capitalises it to the loan principal, the liability in relation to the interest still accrues, and the repayment of both accrued interest and principal must be made by the end of the Shareholder Loan Agreement term. As such, item 3 does not apply.

The Shareholder Loans provided under the Shareholder Loan Agreement, therefore, do not satisfy the equity test under subsection 974-75(1) of the ITAA 1997.

The debt test

The debt test is outlined in subsection 974-20(1) of the ITAA 1997. It states that a scheme satisfies the debt test if:

1. The scheme is a financing arrangement for the entity, and
2. The entity will receive a financial benefit under the scheme, and
3. 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 received under paragraph (b) is received, and
4. It is substantially more likely than not that the value provided will be at least equal to the value received, and
5. the value provided is not nil.

Financing arrangement

A scheme is a financing arrangement for an entity if it meets the definition in subsection 974-130(1) of the ITAA 1997, being a scheme undertaken to raise finance for the entity, or to fund another scheme that is a financing arrangement under paragraph 974-130(1)(a) of the ITAA 1997. The exception to a scheme to raise finance is the issue of a share (item 1 of the equity test). The Shareholder Loans constitute a scheme to raise finance capital for AusCo as they raise finance for AusCo and are not the issue of a share.

Financial benefit received

Subsection 974-60(1) of the ITAA 1997 states that a financial benefit is defined as anything of economic value. The receipt of the loan proceeds by AusCo under the Shareholder Loans constitutes a financial benefit received by AusCo, satisfying this requirement.

Effectively non contingent obligation to provide financial benefits

Subsection 974-135(1) of the ITAA 1997 states that there is an effectively non-contingent obligation (ENCO) if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take action.

An obligation is non-contingent as defined in subsection 974-135(3) of the ITAA 1997 if it is not contingent on any event, condition, or situation (including the economic performance of the entity) other than the ability or willingness of that entity or connected entity to meet the obligation.

As per the considerations outlined above in relation to the equity test, the obligation to pay interest on any outstanding principal under the Shareholder Loans, as well as to pay the principal, is non-contingent, and must be done by AusCo by the end of the loan term. The obligation to make the interest and principal repayments does not depend on the economic performance of AusCo.

When considering whether the payment is effectively non-contingent, regard must be had to the pricing, terms and conditions of the scheme. Paragraph 15 of Taxation Ruling TR 2010/5 Income tax: the relevance of 'economic compulsion' in deciding whether an issuer of a financing arrangement has an effectively non-contingent obligation for the purposes of section 974-135 of the Income Tax Assessment Act 1997 (TR 2010/5) states that the extent of the inquiry is the pricing, terms and conditions of the scheme, which must be considered in the commercial context.

The amounts of the quarterly interest payment to be paid in cash or capitalised to the Shareholder Loan balances depends on the cash flow of AusCo under the terms of the Shareholder Loan Agreement. As discussed, any outstanding principal and accrued interest is due and payable by the end of the term of the Shareholder Loan Agreement. Irrespective of the payment method, whether by cash or capitalisation, the accrual of interest is an ENCO for the purposes of Division 974 of the ITAA 1997. Support for this position is expressed in ATO Interpretative Decision ATO ID 2006/125 Income tax: Term subordinated notes issue: deferred interest and the existence of an effectively non-contingent obligation (ATOID 2006/125). In ATOID 2006/125, a loan agreement allowed for the borrower the option to either capitalise the interest falling due quarterly on the loan or make cash payments. Whether the borrower had an ENCO was not affected if either option was chosen. It was a real amount which the borrower was required to pay or settle with the lender.

The phrase 'ability or willingness' is undefined, but generally refers to situations of capacity to pay. Where the borrower faces significant financial difficulty or is in conflict with the lender, such situations would not be taken to be circumstances where the return was contingent on aspects of economic performance. The inability or unwillingness to pay in such circumstances does not generally constitute a payment dependent on economic performance for the purposes of this Division and therefore the possibility of insolvency does not affect the ENCO analysis.

Value provided equals or exceeds what was received by the entity

Paragraph 974-20(1)(d) of the ITAA 1997 states that the value provided by AusCo must exceed or equal the value received by AusCo. Value provided is defined in subsection 974-20(2) of the ITAA 1997 as the sum of all of the values of all the financial benefits provided or to be provided to other entities party to the scheme. The value received is defined in subsection 974-20(3) of the ITAA 1997 as the value of the financial benefit received under the scheme by AusCo.

Subsection 974-20(4) of the ITAA 1997 restricts the financial benefits that can be taken into account to non-contingent financial obligations. Any obligations contingent on economic performance are disregarded.

Section 974-35 of the ITAA 1997 provides guidance on how to value the financial benefits provided and received. Where the 'performance period', as defined in 974-35(3) of the ITAA 1997 runs for under 10 years, subparagraph 974-35(1)(a)(i) of the ITAA 1997 requires the value provided to be calculated on nominal terms. The performance period is from the date of issue, to the date the ENCO of the issuer to provide a financial benefit in relation to the interest have to be met.

Subsection 974-40(1) and subsection 974-40(2) of the ITAA 1997 state that when doing the calculation, any right to terminate the scheme early is disregarded. Note 1 to subsection 974-40(1) of the ITAA 1997 gives the example of the termination of a loan by discharging the obligation to repay the principal early.

Under the Shareholder Loan Agreement, the Shareholder Loans have the following relevant terms for the purposes of the value test:

·         X year term

·         Principal of $X

·         Interest rate of X% p.a.

·         Repayment of all accrued interest and outstanding principal by the end of the X years

·         Interest accruing daily and being payable quarterly

·         Subject to an excess cash flow clause, either the payment in cash of the accrued interest liability each quarter or the interest accrued being capitalised to the loan principal

Applying the test over the performance period, it is clear that the nominal value that AusCo will provide under the terms of the Shareholder Loan Agreement will exceed the loan proceeds it receives under the arrangement as it will repay the full principal as well as the interest that accrues over time to the lenders. As such, subsection 974-20(4) of the ITAA 1997 will be satisfied.

Paragraph 974-20(1)(e) of the ITAA 1997 states that the value provided and received under the arrangement cannot both be nil. As the amounts under the arrangement are not both nil, paragraph 974-20(1)(e) of the ITAA 1997 is satisfied.

As all of the elements of section 974-20 of the ITAA 1997 are satisfied, the Shareholder Loans therefore satisfy the debt test under section 974-20.

This means that for the purposes of subsection 974-70(1) of the ITAA 1997, having failed the equity test and satisfied the debt test under Subdivision 974-B, the Shareholder Loans are not an equity interest in AusCo.

However, the Shareholder Loans may still be taken to be an equity interest if they are grouped with another interest under the related schemes test under section 974-155 of the ITAA 1997. This test may be operational in these circumstances as the lenders providing the Shareholder Loans to AusCo also hold equal proportions of AusCo shares on issue to the loan capital that they are providing and are only lending the funds to have AusCo pay a return of share capital. The shares in AusCo held by the Consortium are an equity interest under item 1 of the table in subsection 974-75(1) of the ITAA 1997.

Related schemes tests

Subsection 974-155(1) of the ITAA 1997 states that schemes are related to one another if they are related to one another in any way. Subsection 974-155(2) of the ITAA 1997 provides specific examples of schemes that are related:

(a)  Schemes based on stapled instruments

(b)  One of the schemes would, from a commercial point of view, be unlikely to be entered into unless the other scheme was entered into

(c)   One of the schemes depends for its effect on the operation of the other scheme

(d)  One scheme complements or supplements the other, or

(e)  There is another scheme to which both schemes are related.

Subsection 974-155(3) of the ITAA 1997 excludes schemes that merely reference one another, or have a common party.

The definition of related schemes is significantly broad. For example, the Commissioner expresses the view in ATO Interpretative Decision ATO ID 2004/430 Income tax debt/equity: related scheme (ATOID 2004/430) that the issue of loan notes and shares under a single agreement, even if they can subsequently be dealt with separately and independently of one another will still constitute a related scheme for the purposes of section 974-155 of the ITAA 1997.

In this case, the purported related schemes would be the shareholding in AusCo, and the commitments of shareholder debt to fund the capital return on those shares.

Despite the arm's length terms of the Shareholder Loan Agreement, it is unlikely that parties, from a commercial point of view, would have entered into the Shareholder Loan Agreement without them already holding a significant equity interest in the entity and having the ability to participate in and influence the management of AusCo. The Shareholder Loans and shares complement each other in that both forms provide working capital to the AusCo business and the initial loan contributions are calculated based on having an equivalent proportion of the shares. The loan is only provided to fund the return of capital to which the shareholders are taking part.

The Shareholder Loan and the share ownership is also linked by a third scheme; the return of capital that is being funded by the Shareholder Loans.

There is no mention within the Shareholder Loan Agreement of, or any reference to, the shareholders holding shares, or the Shareholder Loans being otherwise linked in legal form to the shareholdings. The Shareholder Loan Agreement, other than its title, in legal form does not relate to the shares, and was issued at a different time to the shares. This however only means that it does not fall within an explicit example of a related scheme, such as a 'stapled instrument' or similar.

On the balance, and due to the significantly broad definition of related scheme, the shareholding in AusCo and the Shareholder Loans provided under the Shareholder Loan Agreement are related schemes as defined by section 974-155 of the ITAA 1997 for the purposes of the debt-equity rules.

Related scheme rules - debt or equity

Under subsection 974-70(2) of the ITAA 1997, two related schemes will together constitute an equity interest if:

(a)  the company enters into, participates in, or causes another entity to enter into or participate in the constituent schemes

(b)  a scheme with the combined effect or operation of the constituent schemes (the notional scheme) would give rise to an equity interest in the company under subsection (1) if the notional scheme came into existence when the last of the constituent schemes came into existence, and

(c)   it is reasonable to conclude that the company intended, or knew that a party to the scheme or one of the schemes intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest.

This is so whether or not the constituent schemes come into existence at the same time and even if none of the constituent schemes would individually give rise to that or any other equity interest.

Under the test, paragraph 974-70(2)(a) of the ITAA 1997 is satisfied as AusCo has entered into the constituent schemes, as have the connected entities, being the controlling shareholders ACo, NR Co and BCo.

Paragraph 974-70(2)(b) of the ITAA 1997 asks whether, if the two schemes were treated as one, the equity test would be satisfied.

As there has been an issue of shares under the arrangement, and those shares contain a right to a variable return from the company contingent on aspects of the company's economic performance, and is paid at the discretion of the company, then the equity test is prima facie satisfied. The Shareholder Loans, being considered together with the shares, do not affect this outcome.

Paragraph 974-70(2)(c) of the ITAA 1997 asks whether it is reasonable to conclude that the company intended the combined economic effects to be the same as, or similar to, the economic effects of an equity interest.

The Commissioner provides an example in ATO Interpretative Decision ATO ID 2003/870 Income tax: debt/equity borderline: characterisation of related schemes (ATO ID 2003/870) of an example of how the debt/equity tests are applied to related schemes constituting a single notional scheme. In that fact pattern, loan notes and shares are found to be related schemes, but the notional amount of equity contributed as compared to the substantial return on the debt interest are such as to ensure that combined, the two instruments satisfy the debt test.

Objectively, it can be reasoned that AusCo did not intend the combined economic effects to be the same as an equity interest, nor did they purport to relate the two schemes in any way. This is because:

·         The Shareholder Loans on their own have a clear economic and legal effect as a debt interest. The shares themselves are a clear equity interest with an unlimited right to amounts related to economic performance and paid at the discretion of the company. The shareholders do not need the combined instruments to have the relevant equity interest.

·         The AusCo shares and Shareholder Loans were issued at different times.

·         The amount of the Shareholder Loans will be a commercial and sustainable level of debt to AusCo, and is subject to arm's length terms and conditions including:

o   a commercial interest rate

o   a requirement to pay cash to the extent of free cash flow, and

o   a clear expectation of repayment of the debt and interest with external cash borrowings and business cash flows within a X year period.

·         The Shareholder Loans are provided under standalone contractual documentation and are not in legal form linked to the shares. AusCo are obliged to perform its obligations to each lender under the Shareholder Loan Agreement, regardless of the terms attached to the AusCo shares.

·         Having regard to normal commercial understandings or dealings in practice, shares in an entity and shareholder loans would commercially be recognised as separate schemes.

·         There is no dependency or interconnectedness between the AusCo equity and Shareholder Loans in that the pricing, terms and conditions do not affect the economic consequences of the other scheme.

·         The Shareholder loans are recognised as debt for legal and accounting purposes.

·         Each shareholder in AusCo is unrelated to each other and operates independently of one another except for the purposes of this particular investment.

·         The respective instruments carry their own separate distinctive rights and obligations and can be dealt with separately from one other.

·         There is no question that the loan scheme, if entered into by third parties, would clearly be a debt interest. While it is the case that the same parties hold both interests this is intended to only be for a limited time as the loan is to be shortly replaced with third party borrowings while the ownership in the shares will continue.

As such, despite being related schemes, there is no intention for the schemes to operate together nor have an intended combined economic effect of equity. As such, subsection 974-70(2) of the ITAA 1997 will not give rise to an equity interest in the company.

However, section 974-80 of the ITAA 1997 covers specific situations described in subsection 974-80(1). These situations are when:

(a)  an interest carries a right to a variable or fixed return from a company

(b)  the interest is held by a connected entity of the company

(c)   apart from this section, the interest would not be an equity interest in the company

(d)  the scheme that gives rise to the interest is a financing arrangement for the company, and

(e)  there is a scheme or a series of schemes designed to operate so that the return to the connected entity is to be used to fund a return to another person (the ultimate recipient).

Additionally, subsection 974-80(2) of the ITAA 1997 states that a scheme or a series of schemes can give rise to an equity interest in a company if:

(a)  the amount of the return to the ultimate recipient is in substance or effect contingent on aspects of the economic performance of:

                      i.        the company

                     ii.        a part of the company's activities

                    iii.        a connected entity of the company or a part of the activities of a connected entity of the company, or

(b)  either the right itself, or the amount of the return to the ultimate recipient, is at the discretion of

                      i.        the company

                     ii.        a connected entity of the company, or

(c)   the interest in respect of which the return to the ultimate recipient is made or another interest that arises from the scheme, or any of the schemes referred to in paragraph (1)(d):

                      i.        give the ultimate recipient a right to be issued with an equity interest in the company or a connected entity of the company, or

                     ii.        is an interest that will, or may, convert into an equity interest in the company or a connected entity of the company.

The section is primarily aimed at sequential arrangements where the return on one interest funds the next. The provision is typically attracted by arrangements between a chain of entities within a wholly owned group.

Section 974-80 of the ITAA 1997 does not apply to AusCo's circumstances to treat the Shareholder Loans as equity interests as

·         the ultimate recipients, being the Shareholders who are participating in the Shareholder Loans receive the interest paid on the Shareholder Loans irrespective of AusCo's or its connected entities' economic performance

·         the interest is not payable at the discretion of AusCo or a connected entity

·         the amount falling due quarterly is not contingent on the return of a different interest or the economic performance of any entity connected to AusCo or AusCo itself.

·         the Shareholder Loan does not give rise to a right to be issued an equity interest in AusCo for the Shareholders and are not convertible to equity.

As such, the Shareholder Loans are not equity interests due to the operation of section 974-80 of the ITAA 1997.

Related schemes - debt under subsection 974-15(2) of the ITAA 1997

Subsection 974-15(2) of the ITAA 1997 invokes a similar test for the debt rules.

For the debt test, paragraph 974-15(2)(a) of the ITAA 1997 is satisfied as it has been determined above that these are related schemes.

Paragraph 974-15(2)(b) of the ITAA 1997 asks whether, if the two schemes were treated as one, the debt test would be satisfied. The testing point is when the last of the constituent schemes came into existence.

The test for a debt interest in section 974-20 of the ITAA 1997 featured in the earlier analysis. As such, the following show that when considered together as related schemes, the shareholding in AusCo and the Shareholder Loans fail the debt test

·         The scheme is a financing arrangement under section 974-130 of the ITAA 1997 as it raises capital finance of both contributed share capital from the shareholders, and debt finance from them as well.

·         The company will and has received financial benefits under the scheme, consisting of the total contributed capital from both debt and share capital sources; this will equate to $X from the shareholders.

·         The company has an ENCO to the extent of the requirement to repay the principal of the debt capital provided, as well as a X% p.a. interest return accruing daily, and to be paid quarterly either by way of cash, or to be capitalised to the loan principal, or a combination of the two.

·         The value received by AusCo under a 'combined scheme' will exceed the amount it will have to repay. This is because there is no obligation to repay the share capital to the shareholders. As such, for the duration of the performance period, the interest repayments and requirement to repay the loan principal will not exceed the amount of share capital. This is in sharp contrast to the factual circumstances in ATO ID 2003/870 where the interest repayments exceeded the contributed share capital.

Paragraph 974-15(2)(c) of the ITAA 1997 asks whether objectively, the company intended the combined economic effects to be the same as, or similar to, the economic effects of a debt interest. This does not have to be considered as the related schemes have together failed the debt test.

Therefore, despite being related schemes, the shareholdings of the Consortium in AusCo along with the Shareholder Loans will not be taken to together constitute a single scheme which is either equity or debt.

As such, each of the schemes will retain their ordinary character under the debt equity rules.

The Shareholder Loans will therefore be debt interests for the purposes of subsection 974-15(1) of the ITAA 1997.

Question 2

Will interest expenses incurred by AusCo under the Shareholder Loans be deductible to AusCo under section 8-1 of the ITAA 1997?

Summary

The interest on the Shareholder Loans will be deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the ITAA 1997 states relevantly that a loss or outgoing incurred in gaining or producing assessable income, or incurred in carrying on a business for the purpose of gaining or producing assessable income is deductible to a taxpayer so long as the loss or outgoing is not capital or of a capital nature.

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 (TR 95/25) discusses the deductibility of interest expenses incurred by taxpayers and the 'refinancing principle' in FC of T v Roberts; FC of T v Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith) in relation to common law partnerships.

In addition, TR 95/25 discusses the applicability of the refinancing principle to companies. In its statement of general principles governing the deductibility of interest, TR 95/25 clearly provides that 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 (Kidston Goldmines v FCT (1991) 22 ATR 168; 91 ATC 4538).

Paragraph 12 of TR 95/25 states that in determining whether interest is deductible, regard must be given to the commercial context in which the company borrowed the relevant funds. For example, there is usually a need for a business to maintain a pool of circulating capital from which to meet the expenses of the business. In such a context, the deductibility of the interest expense cannot be determined by considering only the immediate reason for making a payment and ignoring the overall purpose for which the liability was incurred.

Applying the reasoning in Roberts and Smith,as addressed by TR 95/25, to companies, interest incurred on a borrowing by a company may be deductible where the borrowing is used to fund a repayment of share capital to the shareholders in circumstances where the repaid capital had been and was being employed as capital or working capital in the business carried on by the company for the purpose of deriving assessable income. It is not deductible if the borrowing finances payments to shareholders in reduction or extinguishment of share capital to the extent to which such capital represents amounts paid out of an unrealised asset revaluation reserve or reduction in other equity accounts to the extent they represent unrealised profit reserves.

Example 5 in TR 95/25 illustrates the refinancing principle in the context of a company borrowing funds to pay a return of contributed capital to shareholders. In these circumstances, where the company has, in effect, replaced issued share capital with debt, the principles in Roberts and Smith apply so that the interest on the borrowing would be deductible to the extent that it replaced capital which had been and was being used in the business to produce assessable income.

This analysis must be considered with further detail, where the circumstances arise, by the consolidations regime and the single entity rule (SER) in section 701-1 of the ITAA 1997. The SER broadly states that a consolidated group must be treated as a single entity. All intragroup interactions are ignored for tax purposes, and the assets of a subsidiary of an income tax consolidated group are to be treated as if they are the assets of the head company. The ownership of the shares in the subsidiary by the head company are ignored. Relevantly for the purposes of the deductibility of interest, the nature of the business must be considered in the context of the application of the SER, and only income derived, or expenses incurred, from sources outside of the consolidated group will be considered in such an analysis.

Ordinarily when an entity acquires a company using debt, interest incurred on that debt is deductible on the grounds that the entity is deriving assessable income, being dividend income, from the company which it acquired. However, this analysis is altered in the context of the SER. The subsidiary members of a consolidated group are taken to be parts of the head company for income tax purposes. Instead, the interest incurred on the debt is deductible on the grounds that the entity is acquiring business assets, being the assets of the company that are used to produce assessable income. Tax Determination TD 2006/47 Income tax: consolidation: can the head company of a multiple entry consolidated group claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 for interest paid on funds borrowed after formation of the MEC group from outside the group by it or a subsidiary member to buy shares in an existing eligible tier-1 company of the group? (TD 2006/47) confirms this approach. As such, the SER makes sure that the refinancing principle applies treating the AusCo Group as a single company, rather than of its individual components.

The AusCo Group was capitalised by its shareholders using equity. It used equity to purchase OpCo. As the value of the shares in OpCo are ignored as part of the consolidated group under the SER, the amount is now represented in the underlying assets of OpCo and these assets constitute assets of AusCo. These assets are used to produce the assessable income of AusCo as the head of the consolidated group and are used in carrying on OpCo's business, which is attributed to AusCo as the head of the consolidated group. In the consolidated context, the amounts are needed to maintain a 'pool of circulating capital' to meet the expenses of the business.

AusCo proposes to fund a return of contributed capital to shareholders using the funds advanced by the Shareholder Loans. As determined in Question 1, the Shareholder Loans are debt interests for the purposes of Division 974 of the ITAA 1997. As outlined above, the contributed capital being replaced by the Shareholder Loans is being used in the business operated in the AusCo consolidated group as working capital to produce assessable income. Despite being used to directly fund the capital return, in the context of the AusCo consolidated group as a whole, the Shareholder Loans are in fact replacing working capital. As such, in applying the refinancing principle from Roberts and Smith, as addressed by TR 95/25, any interest payable on the debt used to replace the contributed capital is deductible under section 8-1 of the ITAA 1997.

An outgoing is incurred by an entity if there is the existence of a presently existing liability. It must be an expense that the taxpayer is completely subjected or definitively committed to, and need not necessarily have been paid (FC of T v. James Flood Pty Ltd (1953) 88 CLR 492).

The interest expense on the Shareholder Loans accrues daily and is paid by AusCo to the lender quarterly, either by way of a cash payment if cash-flow allows for such a payment, or alternatively by way of the interest amount being capitalised to the loan. Under either circumstance, the liability has 'come home' to AusCo and AusCo is completely subjected or definitively committed to the relevant outgoing.

The interest expenses incurred by AusCo under the Shareholder Loans are therefore deductible under section 8-1 of the ITAA 1997.

Question 3

Will subsection 45B(3) and section 45C of theITAA 1936 apply in relation to the whole, or a part, of the capital payment received by the AusCo shareholders under the return of capital to be paid by AusCo?

Summary

The Commissioner will not make a determination under section 45C to apply section 45B of the ITAA 1936 as having regard to the relevant circumstances of the scheme, the persons involved in the transaction did not undertake the scheme for the purposes of enabling the shareholders to obtain a tax benefit.

Detailed reasoning

Subsection 45B(2) of the ITAA 1936 provides that section 45B of the ITAA 1936 will apply where:

(a)  there is a scheme under which a person is provided with a demerger benefit or a capital benefit by a company

(b)  under the scheme, a taxpayer (the relevant taxpayer), who may or may not be the person provided with the demerger benefit or the capital benefit, obtains a tax benefit, and

(c)   having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer (the relevant taxpayer) to obtain a tax benefit.

Scheme

Subsection 45B(10) of the ITAA 1936 provides that 'scheme' in section 45B of the ITAA 1936 has the meaning as provided in subsection 995-1(1) of ITAA 1997. That definition is widely drawn and includes any arrangement, scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

For the purposes of section 45B of the ITAA 1936, the proposed distribution of capital to shareholders and subsequent replacement of that capital with Shareholder loans will constitute a scheme for the purpose of paragraph 45B(2)(a) of the ITAA 1936.

Law Administration Practice Statement PSLA 2008/10 Application of section 45B of the Income Tax Assessment Act 1936 to share capital reductions (PSLA 2008/10) provides the Commissioner's instructions to tax officers considering whether or not section 45B of the ITAA 1936 applies to an arrangement. Paragraph 5 of PSLA 2008/10 states that the practice statement is concerned with the kind of reduction commonly referred to as a return of paid up share capital where the capital is surplus to needs or is replaced by debt, as it is in AusCo's circumstances.

Capital benefit

The phrase 'provided with a capital benefit' is defined in subsection 45B(5) of the ITAA 1936. It states that a person is provided with a capital benefit if:

(a)  an ownership interest in a company is issued to the person

(b)  there is a distribution to the person of share capital, or

(c)   the company does something in relation to an ownership interest that has the effect of increasing the value of the ownership interest (which may or may not be the same interest) held by that person.

The distribution to shareholders of AusCo will consist entirely of contributed capital. The capital amount will be recorded as a debit to AusCo's share capital account, and shareholders will receive a distribution of share capital. AusCo shareholders will therefore be provided with a capital benefit within the meaning of subsection 45B(5) of the ITAA 1936.

Tax benefit

A tax benefit is obtained by a relevant taxpayer under the scheme if an amount of tax payable by the relevant taxpayer would, apart from the operation of section 45B of the ITAA 1936, be less than the amount that would have been payable, or would be payable at a later time than it would have been payable, if the capital benefit had been an assessable dividend: subsection 45B(9) of the ITAA 1936.

Under the scheme, AusCo shareholders, as the relevant taxpayers, will obtain a tax benefit because:

·         apart from section 45B of the ITAA 1936, the capital benefit provided as part of the capital return will give rise to CGT event G1. A capital gain would only arise to the extent that the amount of the capital return exceeds the cost base of the shares held

·         to the extent the AusCo shares were not acquired by way of exchange of OpCo shares, it is highly like that when CGT event G1 applies, the cost base of the shares will exceed the amount of the capital benefit received such that no capital gain should arise to the relevant taxpayer. This is because the equity contributed by AusCo shareholders in exchange for shares in AusCo were issued and paid up in December 2018 for a combined amount of $X. AusCo are only proposing to return $X, which is less than the equity initially contributed.

·         CGT event G1, however, may give rise to a capital gain to the extent that the AusCo shares were provided in exchange for OpCo shares.

·         If the capital benefit received was instead assessable as a dividend, income tax would be payable by the relevant taxpayer. As AusCo has a minimal amount of franking credits (insufficient to fully frank a dividend of the magnitude of the return of capital), this would primarily be an unfranked dividend. As such, income tax would be payable on the amount for resident taxpayers and withholding tax would be payable for non-resident taxpayers.

As such, as the impact of the reduced cost base is deferred and the amount received is not immediately taxable, the AusCo shareholders will be taken to receive a tax benefit under the scheme involving the return of capital.

Relevant circumstances

As all the other criteria in subsection 45B(2) of the ITAA 1936 are satisfied, the application of section 45B of the ITAA 1936 turns on whether, having regard to the relevant circumstances of the scheme, it may be concluded objectively that a more than incidental purpose of one of the persons who entered into or carried out the scheme was to enable a taxpayer to obtain a tax benefit.

Subsection 45B(8) of the ITAA 1936 lists the relevant factors in paragraphs 45B(8)(a) to (k) of the ITAA 1936. The list of factors is not exhaustive and not all factors listed will be relevant to every scheme.

Subsection 45B(8) of the ITAA 1936 outlines the following relevant considerations:

(a)  the extent to which the demerger benefit or capital benefit is attributable to capital or the extent to which the demerger benefit or capital benefit is attributable to profits (realised and unrealised) of the company or of an associate (within the meaning in section 318) of the company;

(b)  the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or by an associate (within the meaning in section 318) of the company;

(c)   whether the relevant taxpayer has capital losses that, apart from the scheme, would be unutilised (within the meaning of the Income Tax Assessment Act 1997) at the end of the relevant year of income;

(d)  whether some or all of the ownership interests in the company or in an associate (within the meaning in section 318) of the company held by the relevant taxpayer were acquired, or are taken to have been acquired, by the relevant taxpayer before 20 September 1985;

(e)  whether the relevant taxpayer is a non-resident;

(f)    whether the cost base (for the purposes of the Income Tax Assessment Act 1997) of the relevant ownership interest is not substantially less than the value of the applicable demerger benefit or capital benefit;

(g)  ...repealed

(h)  if the scheme involves the distribution of share capital or share premium - whether the interest held by the relevant taxpayer after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital or share premium;

(i)    if the scheme involves the provision of ownership interests and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests:

a.    the period for which the ownership interests are held by the holder of the interests; and

b.    when the arrangement for the disposal of the ownership interests was entered into;

(j)    ...for a demerger only (NA)

(k)   any of the matters referred to in subsection 177D(2) of the ITAA 1936.

The commercial reasons for the transaction, the background of the establishment of the AusCo Group, and the lack of profits in both AusCo and OpCo lead to the conclusion that the scheme will not be entered into for a purpose of providing AusCo shareholders with a relevant tax benefit.

Ultimately, for the Commissioner to apply section 45B of the ITAA 1936 he must make a conclusion in respect of the presence of a 'more than incidental' purpose of providing a tax benefit by means of the provision of a capital benefit. Although there is a small proportion of profits potentially available for distribution, when looking at the entire scheme holistically and considering the other factors under subsection 45B(8) of the ITAA 1936, the Commissioner is not satisfied that there is a more than incidental purpose of providing a tax benefit to shareholders in this scheme.

Accordingly, the Commissioner will not make a determination under subsection 45B(3) of ITAA 1936 that section 45C of ITAA 1936 applies to the whole, or a part of the payment for the return of capital.

Question 4

Will the return of capital to be paid by AusCo or the crediting of the proceeds of the Shareholder Loans to AusCo's accounts taint the share capital account of AusCo under Division 197 of the ITAA 1997?

Summary

The scheme will not result in a tainting of the share capital account under Division 197 of the ITAA 1997.

Detailed reasoning

Section 197-5 of the ITAA 1997 states that Division 197 applies to amounts transferred to a company's share capital account from another of the company's accounts. Under section 197-50 of the ITAA 1997, a company's share capital account becomes tainted when an amount to which the Division applies is transferred to the account. Share capital tainting generally occurs when profits or retained earnings are capitalised and credited to share capital.

Subsection 975-300(1) of the ITAA 1997 defines a share capital account as

1. an account that the company keeps of its share capital, or
2. any other account that satisfies the following conditions:
   1. The accounted was created on or after 1 July 1998, and
   2. The first amount credited to the account was an amount of share capital.

Subsection 975-300(2) of the ITAA 1997 states that if a company has more than one account covered by subsection 975-300(1) of the ITAA 1997, the accounts are taken, for the purposes of this Act, to be a single account.

In AusCo's accounts, the equity consists of a shareholder capital account, a current profits account, and retained earnings. There are no other accounts 'below the line.'

The shareholder capital account consists of the amount contributed by shareholders to capitalise AusCo to acquire its wholly owned subsidiary OpCo. As such, it is a share capital account for the purposes of section 975-300 of the ITAA 1997.

The other issue is whether the credit from the Shareholder Loans constitutes a credit to share capital or some other account representing share capital. In FC of T v. Consolidated Media Holdings Limited (2012) 250 CLR 503; (2012) 84 ATR 1; 2012 ATC 20-361; [2012] HCA 55, it was held that a buyback reserve and similar accounts set aside consisting part of share capital were part of the single share capital account irrespective of label.

The accounting that is proposed to take place for the scheme is as follows:

Dr Share Capital $X

Cr Shareholder Loan $X

No such situation occurs here. The crediting of a Shareholder Loan account when the loan proceeds are 'received' does not constitute a crediting to the share capital account, and amounts are not credited to the share capital account that is labelled as such. The Shareholder Loan account is an account keeping track of amounts lent to AusCo, not transactions related to the company's share capital.

No amount is credited to the company's share capital account as a result of the return of capital and issue of shareholder loans. An amount may have been transferred if the debt/equity rules applied to treat the Shareholder Loans as a non-share equity interest under Division 974 of the ITAA 1997.

As no amount has been transferred to share capital, the share capital account is not tainted as defined in section 197-50 of the ITAA 1997.

Question 5

Will AusCo be considered a 'foreign controlled Australian company' for the purposes of the thin capitalisation rules under section 820-785 of the ITAA 1997?

Summary

AusCo is not a foreign controlled Australian company for the purposes of the thin capitalisation rules.

Detailed reasoning

An entity is subject to the thin capitalisation rules in Division 820 of the ITAA 1997 if it is controlled by a foreign company or controls foreign companies. The thin capitalisation rules are intended to deny debt deductions where foreign entities load domestic entities with debt in order to shift profits offshore by way of loan repayments, or alternatively, when domestic investors fund their controlled foreign companies with debt to reduce their onshore taxable income when the debt is used to derive what is often exempted branch income or exempt dividends.

AusCo does not have membership interests in any foreign or non-resident company.

Section 820-30 of the ITAA 1997 outlines the objects of Division 820, and states relevantly that the thin capitalisation rules apply to Australian entities that are foreign controlled.

Paragraph 820-785(1)(b) of the ITAA 1997 defines a foreign controlled Australian company as an Australian entity to which a foreign entity holds a thin capitalisation control interest in the company that is 40% or more, and no other entity or entities control the company. A 'thin capitalisation control interest' incudes a direct shareholding.

NR Co holds only X% of the issued shares in AusCo. It has no indirect thin capitalisation control interests in AusCo, as it holds no membership interests in the other two shareholders. As such, AusCo is not a foreign controlled Australian company and does not satisfy the definition.

Question 6

Is AusCo considered an 'outward investing entity (non-ADI)' under subsection 820-85(2) of the ITAA 1997?

Summary

AusCo is a company subject to thin capitalisation rules in Division 820 of the ITAA 1997 as a result of being an associate of an outward investing ADI BCo.

Detailed reasoning

An entity is subject to the thin capitalisation rules in Division 820 of the ITAA 1997 if it is controlled by a foreign company or controls foreign companies. The thin capitalisation rules are intended to deny debt deductions where foreign entities load domestic entities with debt in order to shift profits offshore by way of loan repayments, or alternatively, when domestic investors fund their controlled foreign companies with debt to reduce their onshore taxable income when the debt is used to derive what is often exempted branch income or exempt dividends.

As AusCo is not a foreign controlled Australian company and does not have membership interests in any foreign or non-resident company, it can only fall within the thin capitalisation regime if it is an associate of an entity that is subject to the thin capitalisation regime.

BCo is an outward investing entity (ADI) for the purposes of the thin capitalisation regime. AusCo is not an ADI. As such, item 3 of subsection 820-85(2) of the ITAA 1997 applies in determining if AusCo is subject to the thin capitalisation regime.

Section 820-905(1) of the ITAA 1997 defines an associate entity for the purpose of the thin capitalisation rules.

An entity that is not an individual is an associate entity of another entity at a particular time if, at that time, the first entity is an associate of that other entity and at least one of the following paragraphs applies;

(a)  That other entity holds an associate interest of 50% or more in the first entity;

(b)  The first entity is accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of that other entity in relation to:

                              i.        The distribution or retention of the first entity's profits; or

                             ii.        The financial policies relating to the first entity's assets, debt capital or equity capital

Whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed entities.

The first step is therefore to determine if AusCo is an associate of BCo under the definition of associate in section 318 of the ITAA 1936.

Subsection 318(2) of the ITAA 1936 relevantly lists associates of a company as including (with AusCo being the 'primary entity' and BCo the 'controlling entity'):

(d) another entity (in this paragraph called the controlling entity) where

i. The primary entity is sufficiently influenced by

(A) the controlling entity.

Paragraph 318(6)(b) of the ITAA 1936 states that a company is sufficiently influenced by an entity or entities if the company, or its directors, are accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the entity or entities.

The words 'accustomed or under an obligation, or might reasonably be expected to act' were considered in the controlled foreign companies context in the High Court in BHP Billiton Ltd v. Commissioner of Taxation 2020 ATC 20-735; [2020] HCA 5. The High Court gave the phrase its ordinary meaning.

There is nothing in s 318(6)(b) which specifies how many, or what types of, acts must be "in accordance with the directions, instructions or wishes" of the other entity. The paragraph provides that the act or acts must have been, must be, or must reasonably be expected to be, "in accordance with" the relevant directions, instructions or wishes of the other entity. Whether that is so is a factual inquiry specific to the primary entity and the controlling entity or the directors of those entities. It is a factual inquiry about how and why the company or its directors are accustomed to (past acts), must (present acts), or might reasonably be expected to (future act by reference to some other fact or matter presently existing) act in accordance with the directions, instructions or wishes of the other entity.

39. Thus, the phrase "in accordance with" does not import or require considerations of causation. Indeed, to import considerations of causation would be to ignore the fact that the paragraph applies where a company "might reasonably be expected" to act in accordance with the "directions, instructions or wishes" of another entity. Of course, if such a causal link can be made, then the provision may well be satisfied. But the provision may also be satisfied if the facts provide some other basis to conclude a requisite degree of contribution from the "directions, instructions or wishes" to the act that was, is, or is expected to be, undertaken, or link between them.

40. There is nothing in the text or context of s 318(6)(b) to support Ltd's contention that "sufficiently influenced" requires the controlling entity to be in "effective control" of the other entity, which is in turn subservient to it. Section 318(6)(b) does not use the word "control". It is concerned with influence, not control....

46. Put in different terms, the phrase "sufficiently influenced" identifies a species of influence over the company or its directors which falls short of the control contemplated by s 318(2)(d)(ii) and (e)(ii), namely, control of a "majority voting interest". And that conclusion is reinforced by the fact that the influence can be asserted through the communication of wishes, which are neither directions nor instructions; they are desires. Control is exercised through commands. Where a person controls, or is in effective control of, another, it would be inapt to describe that person's exercise of control as the expression of mere wishes.

Being such a closely held company, there are many circumstances and decisions in relation to AusCo that require unanimous agreement between the shareholders, whether these matters are those requiring unanimous shareholder approval or the unanimous decision of the shareholder nominee directors.

Some of these relate to investment protection, but some go to extraordinary events within the confines of the business. In any event, not only does BCo have a right to participate in the making of such decisions, it has an effective right to veto those decisions, as they must be made unanimously by the shareholder nominated directors of the board, or for shareholder resolutions, by the shareholders themselves.

AusCo is therefore an associate of BCo under paragraph 318(2)(d) of the ITAA 1936 as it is 'sufficiently influenced' by BCo as defined in paragraph 318(6)(b) of ITAA 1936.

The second step is determining whether BCo meets the requirements in paragraphs 820-905(1)(a) or 820-905(1)(b) of the ITAA 1997.

BCo only holds X% of the shares in AusCo. As such it will not satisfy paragraph 820-905(1)(a) of the ITAA 1997.

With respect to paragraph 820-905(1)(b) of the ITA 1997, the issue will be whether BCo has sufficient influence over AusCo with respect to the distribution of profits or capital management strategy.

In the thin capitalisation context, the Commissioner expresses the view as to the meaning of the phrase in accordance with the predecessor to Division 820 of the ITA 1997, former section 159GZE of the ITAA 1936 in Taxation Ruling TR 1992/6 Income tax: whether a non-resident convertible noteholder is a foreign controller for thin capitalisation purposes (TR 1992/6). In TR 1992/6, the Commissioner stated that an entity having a veto right with respect to dividend distribution, or capital management related policies would constitute an entity that has a formal obligation to act in accordance with the direction or instruction of the other entity.

In this case, the shareholder agreement states that issues in relation to the distribution of dividends outside of the dividend policy and the financial policies, including capital management related decisions must be decided unanimously by the shareholders or by the shareholder nominee directors depending on the nature of the issue. The practical effect of that is that any of the three shareholders of AusCo, which all have voting rights both as shareholders and on the board through their shareholder nominee director can veto decisions in relation to those matters. BCo, being a major shareholder, is entitled to a Shareholder Nominee Director and as such can veto decisions under either measure.

As such, AusCo is an associate of BCo as defined in subsection 820-905(1) of the ITAA 1997 for the purposes of the thin capitalisation rules in Division 820 of the ITAA 1997.

Subsection 820-85(2) of the ITAA 1997 outlines when an entity is considered an outward investing entity (non-ADI) for a period. Under item 3, the entity is an outward investor (general) if:

(a)  the entity is an Australian entity through a period, and through that period that is all or a part of an income year, and

(b)  throughout that period, the relevant entity is an associate entity of another Australian entity, and

(c)   that other Australian entity is an outward investing entity (ADI) for that period, and

(d)  The relevant entity is not a financial entity nor an ADI at any time during that period

AusCo is an Australian resident corporation and is an associate of BCo under subsection 820-905(1) of the ITAA 1997 throughout the income year. BCo is an outward investing entity (ADI) throughout that period. AusCo is neither a financial entity nor an ADI at any time during that period.

As such, AusCo is an outward investor (general) under paragraph 820-85(2)(a) of the ITAA 1997 as it meets the requirements in item 3 of the table. As such, it is considered an outward investing entity (non-ADI) and is subject to the thin capitalisation regime in Division 820 of the ITAA 1997, including the assets threshold in section 820-37 of the ITAA 1997.