Senate

Explanatory Memorandum

(Circulated by the authority of the Treasurer the Hon Ralph Willis, M.P.)

Chapter 2 - Accruals assessability of certain securities

Summary of proposed amendments

Purpose of amendments

2.1 To provide a proper accruals basis of taxation for variable return securities to which Division 16E of Part III applies. The present rule which brings to account the fixed component of a variable return security evenly over its term will no longer apply. The amendments will require that the whole return - both fixed and variable - be brought to account on a six monthly compounding accruals basis, consistent with existing Division 16E rules applicable to fixed return securities. This object is expressed in Clause 8 . The amendment will eliminate the distortion inherent in a method which evenly spreads any fixed returns from a variable return instrument which has a declining balance.

2.2 To remove an unintended consequence of Division 16E in relation to certain securities issued in a series. Broadly, where the first security issued in a series is not a qualifying security (ie Division 16E does not apply) and a subsequent security issued in that series would otherwise be a qualifying security (e.g. because it is issued at a discount), the amendments will treat that subsequent security as not being a qualifying security within the scope of Division 16E. This object is expressed in Clause 22.

Date of effect

2.3 The amendments apply to qualifying securities issued after 27 January 1994 [Clause 21] . The further amendment to exclude accruals assessability of certain securites issued in a series applies to qualifying securities issued after 16 December 1984 [Clause 24]

Background to the legislation

2.4 Division 16E was enacted to remove tax deferral opportunities which were available from certain discounted and deferred interest securities. An example would be an investment by an individual taxpayer in a term deposit on which interest was calculated on a compounding basis but not paid until maturity. The financial institution which received the money on deposit would obtain deductions for the interest over the term of the investment but the investor would be taxed only when the interest was actually paid. Deferral of tax in this way meant that investors were willing to accept a lower nominal rate of return because, on an after tax basis, they were better off than if they had made a traditional investment.

2.5 Division 16E was designed to prevent this form of tax deferral by spreading the income and deductions from such investments over the term of the security. It spreads the income and deductions on a basis which reflects the economic gains which have accrued at any point in time.

2.6 Division 16E applies to a class of securities defined as 'qualifying securities'. 'Qualifying securities' are divided into two groups; 'fixed return securities' and 'variable return securities'. Broadly, fixed return securities are those under which the amount of all the cash flows are known at the outset (see definition of 'fixed return security' in subsection 159GP(1)). An example is a fixed interest term deposit. Qualifying securities other than fixed return securities are variable return securities (see current definition of 'variable return security' in subsection 159GP(1)).

2.7 Division 16E treats variable return securities differently from fixed return securities. The taxable return from fixed return securities is brought to account on a six monthly compounding accruals (yield to maturity) basis over the term of the security. This is an actuarial calculation which provides a measure of economic income.

2.8 In contrast, the eligible return from variable return securities is separated into its fixed (or non-varying) and variable (varying) elements. The fixed element, referred to as the 'issue discount', is brought to account on a 'straight line' basis (see current paragraph 159GQ(2)(a) and similar rules in paragraphs 159GQ(3)(a) and (b) for the assessment or deduction of the purchase discount or purchase premium of variable return securities acquired other than on original issue). That is, an equal amount of the fixed element of the return is brought to account in each year of income during the term of the security. Where the security is held for only part of a year of income, an apportioned amount is brought to account in that year.

2.9 The varying element of a variable return security is brought to account on an 'attribution' basis. That is, so much of the varying element as is attributable to the relevant year of income, or which the Commissioner considers may reasonably be attributed to the year, is included in the assessable income of the holder of the security (see paragraph 159GQ(2)(b), and similar rules in paragraph 159GQ(3)(c) for variable return securities acquired other than at original issue).

2.10 The present requirement in paragraphs 159GQ(2)(a) and 159GQ(3)(a) that the fixed element of the return on a variable return security be taxed in equal instalments over the term of the security leads to an accrual of income which is inconsistent with the underlying economic substance of the arrangement. Where the security has a declining balance and the fixed element is a substantial portion of the total return, this can result in significant tax deferral. In economic terms, investments which have a declining balance earn more income in earlier years and less income in later years. In fact, the income component of payments falls to almost zero in the final year.

2.11 Division 16E was intended to tax such securities in a manner consistent with the economic substance of the instrument. While Division 16E achieves this objective for fixed return securities with a declining balance, the spreading of the fixed element in equal instalments over the term of the security means that Division 16E does not achieve its objective for variable return securities with a declining balance, such as indexed annuities.

Securities issued in a series

2.12 Paragraph (e) of the definition of 'qualifying security' imposes an additional qualifying test in relation to fixed return securities. In simple terms, fixed return securities only fall within Division 16E where they are issued at a discount greater than 1.5% per annum. Whether or not a security is a qualifying security is determined at the time of issue of the security.

2.13 It is not uncommon for securities to be issued with exactly the same terms and conditions at different, usually frequent and regular, points in time. This is referred to as issuing securities in a series, although primarily it is to increase the liquidity of the market for the security and to avoid the additional administration costs of establishing a new 'series'.

2.14 Should the required market interest rate rise in the future, it is possible that subsequent issues in a 'series' of securities would come within the scope of Division 16E even though previous issues in that series were outside it. The reason is that, under those conditions, it would be necessary to issue new securities in a series at a discount. Division 16E may then apply.

2.15 In these circumstances, for the purpose of ascertaining the right tax liability it would be necessary to be able to separately identify those securities in the series to which Division 16E applies and those to which it did not apply. However in a practical sense this is not possible because securities issued in a series are fungible and ordinarily not capable of separate identification. The only practical outcome would be to discontinue the series and create a separate series in order to identify securities according to different tax effects.

2.16 This outcome is undesirable as it is likely to have significant adverse implications for the efficient operation of Australia's capital markets. These amendments will prevent such a consequence.

Explanation of amendments - accruals basis of taxation for certain securities.

Section 159GQ repealed; associated definitions repealed

2.17 Under the current law, assessable income in relation to fixed return securities is brought to account on a compounding accruals basis by subsection 159GQ(1). The terms 'eligible notional accrual period', 'notional accrual amount', 'notional accrual period' and 'taxpayer's yield to redemption', as defined in subsection 159GP(1), are incorporated into the application of subsection 159GQ(1). These definitions, and subsection 159GQ(1) itself, are being repealed by the Bill [Clauses 9 and 10].

2.18 The treatment of variable return securities under Division 16E is governed by subsections 159GQ(2) and 159GQ(3). Subsection 159GQ(2) applies where a variable return security is acquired at issue. In that case, the 'issue discount' (as defined in subsection 159GP(4)) is included in assessable income on a straight line basis over the term of the security. These provisions are also being repealed [Clause 10].

2.19 The 'varying element' of the 'eligible return' is brought to account under paragraph 159GQ(2)(b). That paragraph provides that the income amount to be accrued in a period is the amount attributable to that period having regard to the method of calculation of amounts payable under the security and the length of the period, or the amount which in the Commissioner's opinion may reasonably be attributed to that period. Subsection 159GQ(3) applies similarly in relation to variable return securities transferred to the holder after issue. These provisions are being repealed [Clause 10].

The new Division 16E accruals rules

2.20 The amendments contained in the Bill provide consistent accruals accounting rules for both fixed return securities and variable return securities. Where a taxpayer holds a security to which Division 16E applies (a 'qualifying security' as defined in subsection 159GP(1)), new subsection 159GQ(1) specifies that an 'accrual amount' must be calculated for each 'accrual period' in the year of income. If the 'accrual amount' is positive, it must be included in assessable income [Clause 10; new subsection 159GQ(2)]. If the 'accrual amount' is negative, a deduction of the amount is allowable [Clause 10; new subsection 159GQ(3)]. In applying those rules, it is necessary to ascertain the 'taxpayer's maximum term' in relation to the security and to divide that term into 'accrual periods'.

Taxpayer's maximum term

2.21 The maximum term of a taxpayer, in relation to a security, is the remaining term of the security at the time it is acquired by the taxpayer. That is, the maximum term is the period between the acquisition of the security and its maturity. For example, where a taxpayer acquires the security at issue date, the full term of the security will be the taxpayer's maximum term. In effect, the taxpayer's maximum term in relation to a security is the maximum time that the taxpayer could hold that security. While a taxpayer may hold a security for a lesser period (for example, the taxpayer may transfer the security prior to its maturity) this will not reduce the maximum term. See the definition of 'taxpayer's maximum term' in Clause 9; new subsection 159GP(1).

Determination of accrual periods

2.22 Under the present law, the term of a qualifying security is divided into 'notional accrual periods' each of six months set so that the last ends at the maturity of the security: see the definition of 'notional accrual period' in subsection 159GP(1). Where the term of the security is not an exact multiple of six months (eg, 15 months), the first accrual period is the residual part of the first six month period (eg, 3 months for a 15 month security): see the definition of 'eligible notional accrual period' in subsection 159GP(1).

2.23 The concept of 6 monthly eligible notional accrual periods working back from the maturity of the security is being replaced by the rule in, new section 159GQA which requires the taxpayer's maximum term of a security to be divided into accrual periods. Under new section 159GQA where the whole of a year of income falls within the term, that year contains two accrual periods each of six months. Where only a part of a year of income falls within the term, ie either at the commencement of the term or the end of the term, the year may contain an accrual period of less than six months. The following example shows how accrual periods are worked out.

Example 1 - Determination of accrual periods

2.24 Assume the following in relation to a qualifying security acquired by the taxpayer at issue date:

Term 2 Years

Issue date 1 April 1994

Maturity date 31 March 1996

Tax year-end 30 June

The taxpayer's maximum term is two years as the security was acquired at issue date.

Accrual periods are:

1994 year of income	1 April 1994 - 30 June 1994	(3 months)
1995 year of income	1 July 1994 - 31 December 1994	(6 months)
	1 January 1995 - 30 June 1995	(6 months)
1996 year of income	1 July 1995 - 31 December 1995	(6 months)
	1 January 1996 - 31 March 1996	(3 months)

As accrual periods are now wholly within years of income, there is no need to apportion income from accrual periods between years of income.

Determination of accrual amount - fixed return securities

2.25 The amount to be accrued in an accrual period under Division 16E for a fixed return security will be determined by a formula equivalent to that which has applied in ascertaining the 'notional accrual amount' defined in subsection 159GP(1). The formula, in new subsection 159GQB(1) , is as follows:

[Implicit interest rate * Opening balance] - Periodic interest etc.


Calculation of implicit interest rate - fixed return securities

2.26 The implicit interest rate in the formula is the rate per six monthly compounding interval at which the sum of the present values of all amounts payable under the security during the 'taxpayer's maximum term' equals the issue price or transfer price (whichever is relevant) [Clause 10; new section 159GQC].

2.27 Where a taxpayer acquires the security on issue, the implicit interest rate is calculated from the issue date, the issue price being the relevant price. Example 2 illustrates the calculation. Where the security is transferred to the taxpayer, the implicit interest rate is determined from the transfer date, the rate being that at which the present value of all remaining amounts payable under the security equals the transfer price of the security. Example 3 illustrates this.

Example 2: Calculation of implicit interest rate - fixed return security acquired on issue

2.28 Assume the following in relation to a fixed return security:

Security: 2 year term deposit

Principal invested: $1,000

Interest: 5% p.a., payable at maturity (ie, $100 interest)

Issue Date: 1 April 1994

Maturity Date: 31 March 1996

The taxpayer's maximum term is 2 years.

The implicit interest rate is determined by solving the equation:

Present value of all payments under the security = Issue price


i.e. Payment/ (1+ r)n = Issue Price


where:

r: implicit interest rate.

n: number of six month periods, or part thereof, between the issue date and the payment date.

i.e. $1,100 / (1+ r)4 = $1,000


This results in an implicit interest rate of 2.411% (per period of 6 months).

Example 3: Calculation of implicit interest rate - fixed return security acquired after issue date

2.29 Assume the following in relation to a fixed return security:

Security: 2 year deferred interest security

Face Value: $1,000

Transfer Price: $1,040

Interest: 5% p.a., payable at maturity (ie, $100 interest)

Issue Date: 1 April 1994

Transfer Date: 1 May 1995

Maturity Date: 31 March 1996

The taxpayer's maximum term is 11 months.

The implicit interest rate is determined by solving the equation:

Present value of all remaining payments under the security = Transfer price


i.e. Payment / (1+ r)n = Transfer Price


where:

r: implicit interest rate.

n: number of six month periods, or part thereof, between transfer date and the payment date.

$1,100 / (1+ r)(11/6) = $1,040


This results in an implicit interest rate of 3.107% (per period of 6 months).

Adjust implicit interest rate for periods less than 6 months

2.30 Where an accrual period is less than 6 months it is necessary to adjust the implicit interest rate to reflect this [Clause 10; new subsection 159GQB(2)] . For example, if the implicit interest rate of a security was 5% per 6 month compounding interval, the adjusted rate for a two month accrual period is calculated as follows:

r adjusted = (1 + r 6 months)(length of accrual period/6 months) - 1


where:

r adjusted: Implicit interest rate adjusted for an accrual period less than 6 months.

r 6 months: Implicit interest rate for accrual periods of 6 months.

(1 + 5%)(2 months/6 months) - 1


This results in an adjusted implicit interest rate of 1.640% for the two month accrual period.

Calculation of opening balance - fixed return securities

2.31 The 'opening balance' of an accrual period will be determined in accordance with a formula equivalent to that which has applied in determining element "B" of 'notional accrual amount' in subsection 159GP(1). The formula, in new subsection 159GQB(3), is as follows:

Issue/transfer price + Previous accruals - Payments


2.32 The amount ascertained under that formula is referred to as the 'opening balance' because it represents the 'principal' balance outstanding in the compounding accruals calculation at the beginning of the accrual period (ie, the closing balance of the calculation at the end of the previous accrual period).

2.33 The issue price (or transfer price if the security has been transferred to the taxpayer) is the starting point in determining the opening balance. For the first accrual period in relation to the security (ie, that in which the security is acquired by the taxpayer), the opening balance is the issue price (or, if applicable, the transfer price) of the security. "Issue/transfer price" is thus the issue price or the transfer price, as the situation requires.

2.34 If in previous accrual periods in the taxpayer's maximum term there were accrual amounts calculated in accordance with new subsection 159GQB(1) , the sum of any such previous accrual amounts ( "previous accruals ") is added to the issue or transfer price, as the case requires, in determining the opening balance.

2.35 The taxpayer may have received payments under the security, other than amounts that are periodic interest (see subsections 159GP(6) and 159GP(7)) for the purposes of Division 16E, in previous accrual periods. In effect, such payments represent a distribution of 'principal' as they reduce the 'principal' balance of the compounding accruals calculation. Accordingly, any such payments that are made or liable to be made under the security in previous accrual periods within the taxpayer's maximum term ( "payments" ) are subtracted in the calculation of the opening balance in relation to a security.

"Periodic interest etc."

2.36 The third element of the formula for the calculation of accrual amounts is "periodic interest etc." . This will be determined in the same way as element "C" of the existing 'notional accrual amount' in subsection 159GP(1). New subsection 159GQB(4) specifies how "periodic interest etc." is calculated.

2.37 "Periodic interest etc." , consists of two separate elements that are to be deducted in working out the accrual amount for each accrual period. Firstly, any amount that consists of periodic interest (as defined in subsections 159GP(6) and 159GP(7)) is excluded. Periodic interest does not form part of the taxable return from a security that is accrued under Division 16E, but is separately assessable under the general provisions of the Act. It must be excluded in calculating the accrual amount because, as part of the total payments under the security, it is taken into account in calculating the implicit interest rate. Not to exclude periodic interest would therefore constitute a double counting. (See Clause 10; new paragraph 159GQB(4)(a).)

2.38 The second element to be deducted is an adjustment to reflect payments made under the security other than at the end of the relevant accrual period. That kind of adjustment is necessary because the implicit interest rate in the 'accrual amount' formula will reflect an entire accrual period. Payments - either of periodic interest or otherwise - which are made other than at the end of an accrual period effectively reduce the 'principal' balance of the security at the time of payment. Accrual amounts need to be adjusted to properly reflect the reduced balance from that time. New paragraph 159GQB(4)(a) requires such an adjustment to be made in relation to payments of periodic interest made other than at the end of an accrual period. New paragraph 159GQB(4)(b) makes a similar specification in relation to payments other than periodic interest. Example 4 illustrates how this adjustment is calculated.

Example 4: Adjustment where payments made other than at the end of an accrual period.

2.39 Assume the following in relation to an accrual period of a qualifying security:

Length of accrual period: 6 months

Implicit interest rate: 5% (per 6 monthly interval)

Assume also that a payment of $500 is made 3 months into the accrual period.

The early payment means that for three months of the accrual period the 'principal' amount of the security has been less than the opening balance. The adjustment should reflect this. For example, in this case it would be adjusted as follows:

Payment * 5% * Time remaining in accrual period when payment made/Accrual period
$500 * 5% * (3 months/6 months) = $12.50


This results in an adjustment amount of $12.50.

Calculation of accrual amount - fixed return securities

2.40 Because the elements of the accrual amount formula are known in relation to a fixed return security, it is possible to determine the accrual amount for all the taxpayer's accrual periods under the security. Example 5 is an illustration.

Example 5: Calculation of accrual amounts - fixed return securities

2.41 Assume the security has the same terms and conditions of those in Example 1 and 2.

Accrual Period 1 1 April 1994 - 30 June 1994 (3 months)

Calculate the implicit interest rate for a period of less than 6 months

Implicit interest rate per period of 6 months is 2.411% (See example 2).

Implicit interest rate for accrual period 1

i.e. = (1 + 2.411%)(3 months/6 months) - 1
= 1.199%
Opening balance: = $1,000 (issue price)
Periodic interest etc. = Nil
Accrual amount = [Implicit interest rate * Opening balance] - Periodic interest etc.
= 1.199% * $1,000 - 0
= $11.99


Accrual Period 2 1 July 1995 - 31 December 1995 (6 months)

Implicit interest for accrual period 2 = 2.411% per period of 6 months

Opening balance = Issue price + Previous Accruals - Payments
= $1,000 + $11.99 - 0
= $1,011.99
Periodic interest etc. = Nil
Accrual amount = [Implicit interest rate * Opening balance] - Periodic interest etc.
= 2.411% * $1,011.09 - 0
= $24.40


2.42 The following table shows the accrual amount for each accrual period by the application of the formula in subsection 159GQB(1):

Determination of accrual amount - variable return securities

2.43 For variable return securities, the accrual amount for each accrual period is determined under the same formula in new subsection 159GQB(1) that applies for fixed return securities, viz.

[Implicit interest rate * Opening balance] - Periodic interest etc.


2.44 The opening balance and periodic interest etc. are determined in the same manner as explained earlier at 2.31 - 2.39.

2.45 However, because the quantum of payments to be made under a variable return security is not known with certainty at the outset, new section 159GQD requires that a new implicit interest rate be ascertained for each income year in which a taxpayer is the holder of such a security. In a case where there are two accrual periods of six months in the year, the implicit interest rate is the same for both new subsection 159GQD(1).

Calculation of implicit interest rate - variable return securities

2.46 The implicit interest rate in relation to a variable return security is the compound rate per 6 monthly interval at which the sum of the present values of all remaining amounts payable under the security equals the opening balance at the beginning of the year of income. In the first year of income in which the security is held by the taxpayer the opening balance will equal the issue price [Clause 10; new subsection 159GQD(2)]. In calculating the implicit interest rate each year, some or all of the remaining amounts payable under the security may not be known. In some cases, it may not be possible to determine whether an amount will be payable. New subsections 159GQD(4) to (11) specify certain assumptions that are to be made in determining such future payments. These assumptions are discussed in detail at 2.49 - 2.62.

Example 6: Calculation of implicit interest rate - variable return securities

2.47 1994 year of income

Issue Date: 1 April 1994

Assume issue price: $7,500

Assume the payments under the security for the purposes of the accruals calculations (ie, including estimated future payments) for the 1994 year of income are:

Payment Date	Cash Flow
30 June 1994	$1,004.57
30 September 1994	$1,007.09
31 December 1994	$1,009.63
31 March 1995	$1,012.17
30 June 1995	$1,014.71
30 September 1995	$1,017.27
31 December 1995	$1,019.83
31 March 1996	$1,022.39

The implicit interest rate is determined by solving the equation:

Present value of all payments under the security = Opening Balance
i.e. Payments/(1+ r)n = Opening balance


where:

r: implicit interest rate.

n: number of six month periods, or part thereof, between issue date and the payment date.

In the 1994 year of income the opening balance is equal to the issue price of $7,500.

1004.57/(1+ r)(1/2) + 1007.09/(1+ r)1 + 1009.63/(1+ r)(3/2) + 1012.17/(1+ r)2 +
+ 1014.71/(1+ r)(5/2) + 1017.27/(1+ r)3 + 1019.83/(1+ r)(7/2) + 1022.39/ (1+ r)4
= $7,500


This results in an implicit interest rate for the first year of 3.549% (per period of 6 months). The accrual amount for the 1994 year of income is worked out under the formula in new subsection 159GQB(1) , as explained in paragraph 2.25 above.

Possible for implicit interest rate to be negative

2.48 The implicit interest rate would ordinarily be positive for the holder of the qualifying security, but it is possible for it to be negative in relation to a variable return security. This could occur where previous assumptions made in determining unknown future payments under the security cause previous accrual amounts to exceed the total taxable return that is calculated on the basis of assumptions made under current conditions.

Assumptions relating to cash flows the value of which is unknown at the end of the year of income

2.49 In order to calculate both the accrual amount and implicit interest rate in relation to variable return securities, it is necessary to make assumptions to help determine the amount of payments which are unknown as at the end of the relevant year of income. There are two basic rules: the assumption of continuing rate of change (or constant growth) and the assumption of constant level. There is a residual rule to cover situations where neither of these assumptions can apply.

Assumption of continuing rate of change

2.50 An assumption of a continuing rate of change will apply where the amount of a payment unknown at the end of a year of income is calculated or determined by taking into account the amount of change in an index or other thing that occurs during a period [Clause 10; new subsection 159GQD(7)] . This will include, for example, arrangements where future payments under a security are determined by reference to the level of the Consumer Price Index (CPI) at one point in time relative to the level of that index at another (usually earlier) point in time. Examples would be inflation-linked capital indexed bonds and inflation indexed annuities.

2.51 The assumption of a continuing rate of change will also apply to situations where, while the amount of a payment is not explicitly referable to the amount of change in an index or other thing during a period, it may reasonably be regarded as representing that situation [Clause 10; new subsection 159GQD(9)] . For example, payments under an inflation indexed annuity are usually made by reference to a formula where the denominator (eg the level of CPI at the issue of the security), is known at issue date. New subsection 159GQD(9) will cover situations where it is reasonable to conclude in all the circumstances that the calculation incorporates the current level of the CPI index. This would be the case for example where the terms and conditions of a security do not explicitly refer to the level of the CPI index at issue date, but specify a number equal to that level.

2.52 The assumption of a continuing rate of change is not limited to indexed securities or payments involving the level of an index. The phrase 'or other thing' in new subsections 159GQD(7) and (9) is expressed widely, so as to cover all situations where a payment is made, to any extent, by reference to the change in a variable over time, rather than being simply by reference to the value or level of that variable at a particular point in time in the future.

Application of assumption of continuing rate of change

2.53 Where a payment is subject to the assumption of a continuing rate of change, it is to be assumed that the relevant variable will continue to change at the same rate after the end of the relevant year of income as it did during the past year of income [Clause 10; new subsection 159GQD(7)].

2.54 If the rate of change for the 12 months which ends at the end of the year of income is not known at that time (usually because the index or other variable has not been published), the rate of change is to be measured by reference to the latest 12 month period for which relevant information is available. In these circumstances, it is to be assumed that the relevant variable will continue to change at this rate after the time at which the relevant information was last available in the year of income. For example, the latest available CPI figure for a taxpayer whose year of income ends on 30 June is usually that for the March quarter. In this case the rate of change will be determined by reference to the March quarter CPI figure in the current (relevant) year of income compared to the March quarter CPI figure in the previous year. Example 7 illustrates this process.

Example 7: Application of assumption of continuing rate of change - inflation indexed annuity

2.55 Assume the following in relation to an inflation indexed annuity variable return security.

Term: 2 years

Issue Date: 1 April 1994

Maturity Date: 31 March 1996

Payment Frequency: Quarterly

Payment Dates: 30 June 1994, 30 September 1994, 31 December 1994, 31 March 1995, 30 June 1995, 30 September 1995, 31 December 1995, 31 March 1996.

Assume March 1993 figure: 108.9

Assume December 1993 figure: 109.5

Assume March 1994 figure: 110

Taxpayer's tax year end: 30 June

Payment formula:

Minimum Annuity Payment * CPIn/ CPIo


where:

A Minimum Annuity Payment of $1,000 is provided under the annuity.

CPIn: Last CPI figure known at payment date n.

CPIo: Last CPI figure known at issue date, in this case the December 1993 quarter figure.

This is a security to which the assumption of continuing rate of change will apply, as the payments are calculated by reference to the change in the CPI index during a period.

The first payment under the terms of the security is made on 30 June 1994. All payments under the security subsequent to 30 June 1994 will be unknown as at that time, as the relevant CPI figures would not be available.

The rate of change in the CPI index for the purposes of applying the continuing rate assumption in the 1994 year of income is determined as follows:

(CPI March 94-CPI March93)/CPI March93 = (110-108.9)/108.9 = 1.01% per annum


Therefore, for the purposes of the accruals calculations for the 1994 year of income, the CPI is assumed to increase at the rate of 1.01% per annum. As the June 1994 CPI will not be known on 30 June 1994, it is worked out for accruals purposes as follows:

CPI June 94 CPI March 94 * (1+ 1.01%)(3 months/12 months)
110 * (1.0101)(1/4) = 110.2767


The first unknown payment, on 30 September 1994, is therefore estimated to be:

$1,000 * CPI June 94/CPI December 93
$1,000 * 110.2767/109.5
$1007.09


By the same methodology, payments under the security for the purposes of calculating the accrual amount for the 1994 year of income would be:

Payment Date	Cash Flow
30 June 1994	$1,004.57
30 September 1994	$1,007.09
31 December 1994	$1,009.63
31 March 1995	$1,012.17
30 June 1995	$1,014.71
30 September 1995	$1,017.27
31 December 1995	$1,019.83
31 March 1996	1,022.39

Assumption of constant level

2.56 Another basis of assumption, the constant level assumption [new subsection 159GQD(5)] , applies where a payment under a qualifying security is calculated (to any extent) by reference to the amount or level, at a particular time, of a rate, price, index or other measure. The expression 'rate, price, index or other thing' in new subsection 159GQD(5) would encompass all manner of variables intended to form part of the calculation of a payment under a qualifying security. Example 8 illustrates when that assumption would apply.

2.57 Where a payment is subject to the assumption of constant level, it is to be assumed that the relevant variable will remain the same after the end of the relevant year of income as it was when it was last available in the relevant year of income [Clause 10; new subsection 159GQD(5)].

Example 8: Payment to which the assumption of constant level will apply

2.58 Assume the following in relation to a variable return security:

Security: 2 year floating rate note

Face Value: $1,000

Interest: Bank Bill Rate (BBR) per annum at maturity, payable at maturity. BBR is an indicator of the current bank bill rate, and is available daily.

Issue Date: 1 April 1994

Maturity Date: 31 March 1996

The interest payment at maturity under this security is calculated at that time as follows:

BBR (pa)maturity * Face Value * Term (in years)


The assumption of constant level will apply to this payment, as it is calculated by reference to the level of a rate (BBR) at a particular time.

As at the end of the 1994 year of income, the amount of the payment due at maturity is unknown, as it is dependant on the future level of BBR. In order to calculate the implicit interest rate and the accrual amount for the 1994 year of income, it is necessary to determine a value of this amount payable. As the constant level assumption applies to this security, for the purposes of the 1994 year of income the amount of the payment due at maturity will be assumed to be based on the level of BBR as at 30 June 1994. If BBR is 6% p.a. on 30 June 1994, the determination is as follows:

BBR (pa)maturity * Face Value * Term (in years)
i.e. 6% * $1000 * 2 years.


Residual assumption

2.59 Where the amount of a future payment cannot be determined on the basis of the assumptions of a continuing rate of change or constant level or both, the amount is to be determined on the basis of what is most likely in the circumstances. This rule would apply where there is no relevant rate, price, index or other variable available in the year of income.

2.60 The determination of what is most likely does not require that there be certainty as to what the amount of the payment will be. Rather, the determination is to be reasonably made on the balance of the probabilities of likely outcomes.

2.61 In rare cases, it may not be possible at the end of year of income to determine a future payment of payments on the basis of what is most likely. The mere fact that there may be a range of possible future outcomes would not, however, preclude a determination being made on that basis.

More than one assumption can apply to a payment

2.62 In relation to some payments under a security, several factors or variables may need to be taken into account in determining what is actually paid. In those cases, different assumptions may apply in relation to the different variables. Accordingly new subsection 159GQD(4) provides that the determination of unknown payments is to be made by applying the assumptions specified in new subsections 159GQD(5) , (7) or (11), or a combination of those assumptions. New section 159GQD is not to be read as meaning that if any part of an unknown payment cannot be determined then the whole of that payment is estimated to be zero, but rather that the assumptions of continuing rate of change, or constant level, or the residual "most likely" rule, are to apply in estimating future payments, or parts of payments, to the extent possible.

Treatment of issuers; new subsections 159GT(1), (1A), (1B), and (1C).

2.63 Division 16E applies symmetrically to holders and issuers of qualifying securities through the operation of subsection 159GT(1). It authorises a deduction to an issuer in a year of income of an amount equal to that which the original holder of the security would have included in assessable income under subsection 159GQ (assuming the original holder held the security until the end of its term).

2.64 As discussed at paragraphs 2.17 to 2.19, section 159GQ is to be repealed. Under new subsection 159GQ(3) , it will be possible in certain circumstances for a deduction to be allowed to the holder of a qualifying security prior to the disposal of that security either by way of transfer or at maturity (see paragraph 2.20 above). To maintain consistency of treatment under Division 16E as between holders and issuers of qualifying securities, it is necessary to amend subsection 159GT(1) to provide for an amount to be included in the assessable income of an issuer where the original holder would have been allowed a deduction for an amount during the term of the security [Clause 13; new subsection 159GT(1B)] . Issuers are allowed deductions on a similar basis as currently available under subsection 159GT(1) by Clause 13; new subsection 159GT(1A).

Associated amendments

2.65 Section 159GQ is to be repealed. Subsection 159GR(2) currently provides for an adjustment to be made where subsections 159GQ(2) or 159GQ(3) have resulted in an incorrect accrual of income in relation to a payment under a variable return security. On the repeal of section 159GQ, subsection 159GR(2) is to be omitted as redundant [Clause 11].

2.66 A number of provisions in the Assessment Act currently refer either to subsection 159GR(2), or amounts being included in the assessable income or allowed as deductions under section 159GR. These references are to omitted as redundant. The provisions amended in this way are:

Subsection 159GR(1) [Clause 11]

Subsection 159GS(3) [Clause 12]

Subsection 159GW(1) [Clause 14]

Section 159GX [Clause 15]

Section 159GY [Clause 16]

Subsection 63(1A) [Clause 17]

Paragraph 159GZZZZE(2)(b) [Clause 18]

Paragraph 221YSA(4)(a) [Clause 20]

2.67 Paragraph 221YHZA(2B)(b) includes a reference to income included under paragraph 159GR(2)(c). The paragraph 221YHZA(2B)(b) is being revised [Clause 19; new paragraph 221YHZA(2B)(b)] to remove the reference.

2.68 Subsection 159GT(4) is the equivalent provision for issuers of qualifying securities to subsection 159GR(2) in relation to holders. Like subsection 159GR(2) it is to be omitted as redundant on the enactment of Clause 13; new section 159GQ.

Explanation of amendments - securities issued in a series

Definition of qualifying security amended

2.69 Division 16E is amended by this Bill to ensure that later issues in a series of securities will not fall within the scope of the Division where securities in the first issue of that series are outside its scope.

2.70 The definition of 'qualifying security' in subsection 15GP(1) is amended by the insertion of a new paragraph, (ba). It specifies that a security is not a qualifying security if it is 'part of an exempt series' [Clause 23 (a)]

Exempt series of securities

2.71 The circumstances in which a security is part of an exempt series are set out in new subsection 159 GP(9A).

2.72 In order for a security to be regarded as issued as part of an exempt series the first security issued in the series after the commencement date of Division 16E (ie 16 December 1984) must not be a 'qualifying security', as defined in subsection 159GP [Clause 23(b);new subsection 159GP(9a)].

2.73 To be treated as issued in the same series, securities must have exactly the same payment dates, payment amounts and be the same in respect of all other terms [Clause 23(b); new paragraphs 159GP(9A)(b),(c)] . In short, securities issued in a series must have precisely the same terms and conditions. They should, for example, have the same rate of interest, and the same payment and maturity date irrespective of issue date. However the fact that, in a given case, securities could be separately identified, e.g. by serial number, would not preclude their being treated as issued in a series.

2.74 Nor will the fact that a security has a different issue price from another security have a bearing on whether they were both issued in the same series [Clause 23(c); new subsection 159GP(9B)].

2.75 Specifically, the amendments provide that where:

•

the first security issued in a series after 16 December 1984 is not a qualifying security; and

•

at a later time, the same issuer issues another security in that series, ie with the same payment dates, payment amounts and other terms as the first in the series

the later security is part of an exempt series [Clause 23(b); new paragraphs 159PG(9A)(a),(c)]

2.76 That is, later securities will not be treated as qualifying securities under these rules if the very first securities issued in the series were not qualifying securities.