House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon Peter Costello MP)

Chapter 6 - Debt and equity interests

Outline of chapter

6.1 Schedule 6 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to:

•

deem related party at call loans to small companies to be debt under the debt/equity rules (paragraphs 6.2 to 6.32)

•

make a number of minor technical amendments to ensure that the debt/equity rules work as intended (paragraphs 6.33 to 6.39). The technical amendments will have effect from 1 July 2001.

Context of amendments - related party at call loans

6.2 A 'related party at call loan' is an undated loan repayable on demand by a connected entity. Many small companies acquire finance by at call loans. In many cases the owners of the company will deposit cash into the company's bank account as required and withdraw cash when the company has sufficient funds. The owners generally treat deposits as a loan or loans and each withdrawal as a repayment or part repayment.

6.3 The debt/equity rules in Division 974 of the ITAA 1997 determine which interests in a company are debt and which are equity for income tax purposes. Under the debt/equity rules, at call loans may be characterised as equity interests rather than debt interests. This means that outgoings in relation to the loan may be treated as frankable dividends. Generally, record keeping is more onerous and compliance costs greater if the loans are treated as equity than otherwise would be the case.

6.4 The Minister for Revenue and Assistant Treasurer announced in Press Release No. 063 of 15 July 2005 that the Government would amend the income tax law to deem certain related party at call loans to small businesses to be debt under the debt/equity rules.

6.5 The objective of this measure is to lower compliance costs for small business.

Summary of new law - related party at call loans

6.6 The amendments will deem certain schemes to be debt under the debt/equity rules in Division 974. This means the scheme will be treated as a debt interest in a company for tax purposes. The amendments apply if:

•

the scheme is a related party at call loan

and

•

at the end of an income year, the company has an annual turnover of less than $20 million.

Comparison of key features of new law and current law - related party at call loans

Detailed explanation of new law - related party at call loans

6.7 The amendments deem, in a year of income, certain schemes to be debt under the debt/equity rules in Division 974. This means that such a scheme will be treated as a debt interest in a company for tax purposes in that year of income. The amendments apply if, in the year of income:

•

the scheme is a related party at call loan [Schedule 6, item 8, paragraph 974-75(6)(a)]

and

•

the company satisfies the turnover test [Schedule 6, item 8, paragraph 974-75(6)(b)] .

6.8 If these conditions are satisfied, Division 974 will deem all related party at call loans of the company to be debt interests for that year of income. [Schedule 6, item 8, subsection 974-75(6)]

6.9 If these conditions are not satisfied, the related party at call loan may give rise to an equity interest depending on the pricing, terms and conditions of the scheme.

Step 1: are there any schemes that are related party at call loans to a company?

6.10 The deeming only applies to schemes which are related party at call loans:

•

The scheme must take the form of a loan to a company by a connected entity.

•

The loan must not have a fixed term.

•

The loan must be repayable on demand by the connected entity or on the death of the connected entity.

[Schedule 6, item 6, paragraph 974-75(4)(c); item 8, paragraph 974-75(6)(a)]

6.11 A loan is 'repayable on demand' if, under its express or implied terms, the lender can demand repayment at any time. An example of such a loan is one where there are no express terms, but it is apparent from the circumstances that parties anticipate repayment on demand.

6.12 A loan may be repayable on demand if there is a notice period between the time of demand and the time payment is due, so long as the period is not longer than is reasonably necessary to arrange payment. For example, a loan which is expressly stated to be repayable 'within 14 days of written demand by the lender' may be repayable on demand.

6.13 The terms 'scheme' and 'connected entity' are defined in subsection 995-1(1) of the ITAA 1997. A 'scheme' is any arrangement, plan, proposal, action, course of conduct or action, whether unilateral or otherwise. A 'connected entity' of the company is any 'associate' or member of the same wholly-owned corporate group. 'Associate' is defined in subsection 995-1(1) of the ITAA 1997.

Example 6.1: Schemes that are related party at call loans

Meggan owns and controls a small company, Meggan Pty Ltd.

The company requires an additional $5,000 cash to cover operating expenses in the next month. Meggan transfers this amount from her personal cash account to the company's account. Meggan anticipates the company will repay this amount whenever she seeks it. This will likely be when the company has sufficient profits or cash flow. The company records a liability owed to Meggan in its accounts. Otherwise, there is no documentation of the loan.

The company also needs $100,000 to purchase new equipment. Meggan agrees to lend this amount to the company and has her solicitor draw up a loan agreement between her and Meggan Pty Ltd. The agreement says the loan is 'repayable within 14 days of written demand by the lender'. The agreement does not specify a term for the loan. No interest is payable.

In deciding whether the loans to Meggan Pty Ltd are related party at call loans, the relevant taxpayer is Meggan Pty Ltd.

As Meggan owns the company she is an associate of the company and therefore a 'connected entity'.

Neither loan has a fixed term.

Both loans are repayable on demand because Meggan may demand repayment at any time and the company is obliged to pay her. This is the case even though the first loan is silent as to repayment and the second loan requires 14 days notice.

Step 2: does the company pass the turnover test?

6.14 The second step is to determine if the company satisfies the turnover test. [Schedule 6, item 8, paragraph 974-75(6)(b)]

Turnover test

6.15 To pass the turnover test, the company's annual turnover must be less than $20 million. A company's annual turnover is to be calculated in the same way that it is for goods and services tax (GST) purposes. 'Annual turnover' is measured as prescribed in Division 188-10 of the A New Tax System (Goods and Services Tax) Act 1999 . [Schedule 6, item 8, subsection 974-75(7)]

Consequences of qualifying for deemed debt treatment

6.16 If a scheme qualifies for 'deemed' debt treatment, it means the scheme will receive debt treatment under subsection 974-75(6) of the debt/equity rules in Division 974. [Schedule 6, item 8, subsection 974-75(6)]

What happens when the scheme ceases to qualify or begins to qualify?

6.17 A scheme may qualify for deemed debt treatment under the debt/equity rules in one year but not the next year because the company ceases to satisfy the turnover test. This means that related party at call loans to the company could change from being debt interests to being equity interests.

6.18 On the other hand, a scheme may not qualify in one year, but begin to qualify in the next year. This would be because the company does not pass the turnover test in the first year but passes the test in the second year. In this case, deeming applies to related party at call loans to the company from the beginning of the second income year. [Schedule 6, item 8, subsection 974-75(6)]

6.19 In light of this, taxpayers may wish to alter their loans so they are debt interests under the debt/equity rules. Taxpayers that are private companies may elect to treat this change as if it occurred at the beginning of the previous income year. They must make this election before the earlier of the due date for the company's tax return or the date of actual lodgement for that year. This removes the need to treat the loan as an equity interest for that previous year. [Schedule 6, items 9 to 12, subsections 974-110(1A) and (1B)]

6.20 Diagram 6.2 illustrates what happens when a private company makes the election.

Application and transitional provisions - related party at call loans

6.21 The amendments apply to:

•

schemes entered into on or after 1 July 2005

and

•

schemes entered into before 1 July 2005, in so far as they continue to exist at that date.

[Schedule 6, item 13 ]

6.22 Under subsection 974-75(4) all related party at call loans are treated as debt interests until 1 July 2005.

6.23 The treatment of related party at call loans entered into before 1 July 2005 and still in existence on that date may change on that date. If the scheme qualifies for deemed debt treatment, it will continue to be treated as a debt interest. If the scheme does not qualify, this may give rise to an equity interest, depending on their particular pricing, terms and conditions.

6.24 The terms and conditions of a related party at call loan may be changed before 1 July 2005 so it becomes a debt interest under section 974-15 of the ITAA 1997. This Bill ensures that the debt/equity rules will treat the loan as a debt interest on and after 1 July 2005. [Schedule 6, item 22, subsection 974-75(5)]

6.25 These amendments will apply from 1 July 2005. The existing transitional provision in subsection 974-75(4) which deemed related party at call loans to be debt, expired on 30 June 2005. The 1 July 2005 application date will ensure continuing deemed debt treatment for the related party at call loans of those small companies that qualify for deemed debt treatment.

6.26 Although these amendments are retrospective, taxpayers will not be adversely affected. The amendments, in combination with the technical amendments, will provide all taxpayers with the opportunity to enjoy the compliance cost savings of debt treatment for related party at call loans.

Consequential amendments - related party at call loans

6.27 This Bill amends the existing rule which treats related party loans as debt interests until 1 July 2005. It ensures this transitional rule defines 'related party at call loans' in the same way as for small business deemed debt treatment. This is to remove any doubt that the small business deemed debt treatment and the existing transitional rule apply to the same type of loans. [Schedule 6, item 6, paragraph 974-75(4)(c)]

6.28 This Bill amends the non-share capital account provisions to clarify that a company will have a non-share capital account if:

•

a debt interest in a company changes to an equity interest as a result of a material change under subsection 974-110(1) or (2)

•

a related party at call loan that is taken to be a debt interest under subsection 974-75(4) prior to that provision ceasing to have effect becomes an equity interest on 1 July 2005 because the company does not qualify for deemed debt treatment

or

•

the small company deemed debt treatment applies to a related party at call loan in a particular year of income but not the subsequent year of income and such loan will be an equity interest at the start of that subsequent year of income.

[Schedule 6, item 1, paragraphs 164-10(1)(c) to (e)]

6.29 This Bill also ensures there will be a credit to the non-share capital account where a non-share capital account arises as a result of:

•

a debt interest in a company changing to an equity interest as a result of a material change under subsection 974-110(1) or (2)

•

a related party at call loan being treated as an equity interest on 1 July 2005 because subsection 974-75(4) no longer applies and the company does not qualify for deemed debt treatment

or

•

the small company deemed debt treatment applies to a related party at call loan in a particular year of income but not the subsequent year of income and such loan will be an equity interest at the start of that subsequent year of income.

[Schedule 6, item 2, subsection 164-15(2)]

6.30 Where a related party at call loan gives rise to a non-share equity interest during a year of income but subsequently the at call loan is taken to be a debt interest by subsection 974-75(6) or 974-110(1A) in relation to the year of income, a credit is taken never to have arisen. [Schedule 6, item 3, subsection 164-15(5)]

6.31 There is a debit to the non-share capital account if:

•

an equity interest in a company changes to a debt interest as a result of a material change under subsection 974-110(1) or (2)

•

an equity interest of a private company changes to a debt interest as a result of the application of subsection 974-110(1A)

or

•

the small business deemed debt treatment applies to an interest that was an equity interest at the end of the previous year. This debit will occur at the start of that second year of income.

[Schedule 6, item 4, subsection 164-20(3)]

6.32 Where a related party at call loan appears to give rise to a debt interest during the year of income but it is subsequently determined that this is not the case a debit in the non-share capital account in respect of the loan, being classified as a debt interest, is taken never to have arisen. [Schedule 6, item 5, subsection 164-20(4)]

Context of amendments - technical amendments

6.33 The Minister for Revenue and Assistant Treasurer announced in Press Release No. 002 of 5 August 2004 that the Government would amend the debt/equity rules in light of technical issues raised by taxpayers. The amendments will ensure that the provisions operate as intended.

Summary of new law - technical amendments

6.34 This Bill makes technical amendments to ensure that the debt/equity rules in Division 974 of the ITAA 1997 operate as intended.

Detailed explanation of new law - technical amendments

6.35 This Bill makes the following technical amendments to the ITAA 1997 and the Income Tax Assessment Act 1936 (ITAA 1936):

•

ensures that the issue of non-equity shares does not give rise to a capital gain [Schedule 6, items 16 to 21 and 28 to 32, paragraphs 104-35(5)(c) and (e ), 104-155(5)(c) and (e ) and section 109-10 ]

•

corrects a defect in the transitional rules for the debt/equity rules so that a non-share capital account and credits to that account arise appropriately when the taxpayer elects to apply the debt/equity rules from 1 July 2004 [Schedule 6, items 26 and 27, subitems 118(2 ) and 118(9 ) of Schedule 1 to the New Business Tax System ( Debt and Equity ) Act 2001 ]

•

corrects several errors in section references [Schedule 6, items 14, 15, 23 and 24, subsections 160AOA(2), 160APAAAB(6), 974-105(1) and 974-110(1) and (2)] .

Application and transitional provisions - technical amendments

6.36 These amendments are to be taken to have commenced immediately after the commencement of the New Business Tax System (Debt and Equity) Act 2001 . That Act commenced on 1 July 2001. [Schedule 6, item 25 ]

6.37 The amendments relating to non-equity shares apply in two stages. The first stage is in items 16 to 24 of the Schedule. These amendments will be taken to have commenced on 1 July 2001, which was the commencement date for the inclusion of the debt/equity rules in the ITAA 1997. These amendments therefore will date back to a time before the definition of 'non-equity share' was inserted into the ITAA 1997 (that definition was not inserted until 29 June 2002). This means they must instead refer to the definition of that expression that was then in the ITAA 1936.

6.38 The second stage is in items 28 to 32 of the Schedule. These commence on Royal Assent, to take account of the fact that 'non-equity share' is now defined in the ITAA 1997 as having the same meaning as it has in the ITAA 1936.

6.39 These amendments are retrospective. However, taxpayers will not be adversely affected. The amendments will address technical issues brought to the attention of the Minister for Revenue and Assistant Treasurer by taxpayers and reduce confusion caused by defects in the debt/equity rules.

REGULATION IMPACT STATEMENT

Policy objective

6.40 The objective of the proposed amendment is to lower compliance costs for small business in respect of their related party at call loans.

Background

6.41 The treatment of related party at call loans under the debt/equity rules in Division 974 carry record keeping and other compliance costs for companies. While larger companies are capable of absorbing these costs, smaller companies may be adversely affected by the additional compliance costs.

Implementation options

6.42 The issue of compliance costs for small companies has arisen because of the possible treatment of related party at call loans as equity interests under the debt/equity rules in Division 974 of the ITAA 1997. These compliance costs arise from the need to keep specific tax accounts as a result of their related party at call loan being treated as an equity interest or incur costs in formalising their at call loan agreements so as to avoid equity treatment. Equity treatment would mean any interest payments would lose their tax deductibility.

6.43 Various options (see below) were considered for reducing the compliance costs of small companies with related party at call loans.

Assessment of impacts

Impact group identification

Small companies

6.44 The reduction in compliance costs for small companies is to be achieved by deeming their related party at call loans to be debt interests in accordance with the debt/equity rules in Division 974 of the ITAA 1997. The impact of the amendments on small companies will likely flow through to the tax agents of those small companies.

Australian Taxation Office

6.45 As the Australian Taxation Office (ATO) is charged with administering the debt/equity rules, it will be directly affected by the amendments.

Analysis of costs / benefits

6.46 This section outlines the costs and benefits of all options considered. The following analysis of costs and benefits is qualitative because a quantitative analysis was not possible due to the lack of data available on small companies. The ATO would incur some small, initial costs in staff becoming familiar with the test, but going forward there is expected to be less need for work on related party at call loan issues.

Option 1: qualification for loans where a company is eligible for small business CGT $5 million net asset value test

Small companies

6.47 Submissions, particularly those received following the release of the Treasury discussion paper Review of the application of the debt/equity provisions of the income tax law to certain post-30 June ' at call' loans in April 2004, advanced many options, though this option was generally favoured.

6.48 The use of the net asset value test in this context would involve using the test more regularly than currently is the case. At present, the test is applied only on disposal of a capital gains tax (CGT) active asset. The test is also relatively costly in terms of compliance, as an annual valuation of assets would need to be undertaken.

6.49 This option could also increase workloads for tax agents and other specialists required to provide asset valuation services.

Option 2: qualification based on annual turnover of the company

Small companies

6.50 This option was supported by participants at a consultation meeting on 4 April 2005, and in subsequent submissions. This test is already used by small companies for GST purposes. It is expected that this option will have minimal compliance costs due to small company familiarity with annual turnover, and would not impact on taxpayer behaviour.

6.51 This option may well reduce the demand for tax agent services.

Option 3: allowing private companies to formalise their at call loans so that they will be debt interests

Small companies

6.52 This option would provide private companies with the opportunity to ensure debt treatment of related party at call loans, avoiding the compliance costs associated with equity treatment.

6.53 However, private companies which choose to formalise loans to ensure debt treatment of related party at call loans would bear costs from the drafting of the loan contract and the tracking of the loan through accounting systems.

6.54 This option is expected to increase the workload of tax agents in assisting private companies to formalise related party at call loans.

Consultation

6.55 In line with the Government's commitment to community consultation on tax policy and law design (Treasurer's Press Release No. 022 of 2 May 2002), the Treasury has conducted a targeted public consultation process.

6.56 On 7 April 2004, the Treasury published a discussion paper on the taxation of related party at call loans. Almost 40 parties made submissions in response to the discussion paper.

6.57 In March 2005, the Government invited parties who had made submissions to view draft legislation and make comments. Treasury officials met with interested parties.

Conclusion and recommended option

6.58 The Government decided to apply an annual turnover test of less than $20 million to determine whether a company's related party at call loan should be subject to the debt/equity rules. The Government also decided to allow private companies with a turnover of $20 million or more to formalise their related party at call loans to ensure debt treatment and thus reduce compliance costs.

6.59 Option 1 was discarded because its application would impose high compliance costs.

6.60 The estimated cost to revenue is up to $14 million per annum. Based on assumptions used to determine the impact of the amendments on the Budget, it is estimated that the related party at call loans of approximately 98,000 companies will be deemed as debt under the debt/equity rules.

6.61 The Treasury and the ATO will monitor these taxation measures, as part of the whole system, on an ongoing basis.