House of Representatives

Explanatory Memorandum

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

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Small business CGT provisions

Schedule 1 to this Bill amends the Income Tax Assessment Act 1997, the Income Tax Assessment Act 1936 and the Income Tax (Transitional Provisions) Act 1997 to reduce the compliance costs for small business and increase the availability of the small business capital gains tax (CGT) concessions.

These amendments also replace the controlling individual 50 per cent test with a significant individual 20 per cent test that can be satisfied either directly or indirectly through one or more interposed entities.

Date of effect : These amendments apply to CGT events that happen in the 2006-07 and later income years. One amendment is to insert a transitional provision to ensure that the small business roll-over operates as intended for CGT events that happen in the 1998-99 to 2005-06 income years.

Proposal announced : The amendments that are in response to the Board of Taxation recommendations, and the change to the controlling individual test were announced in the 2006-07 Budget (Treasurer's Press Release No. 038 of 9 May 2006). The remaining changes have not been announced.

Financial impact : The announced amendments will have these revenue implications:

The cost of the additional measures is unquantifiable but expected to be minimal.

Compliance cost impact : Minimal.

Summary of regulation impact statement - for the significant individual test

Regulation impact on business

Impact : An individual can operate a small business either directly or through a company or trust structure. In the case where a small business is operated through a company or a trust it is necessary to establish the percentage of active participation the individual has in the business.

The law replaces the controlling individual 50 per cent test with a significant individual 20 per cent test which establishes the participation percentage of an individual for this purpose.

A regulation impact statement was prepared in respect of the significant individual 20 per cent test. Taxpayers affected by this amendment are those who carry on a small business through a company or a trust and who currently would not satisfy the controlling individual 50 per cent test.

Main points :

•

This measure will increase the number of individual's who will be able to access the small business concessions because of the reduced participation percentage of 50 per cent (controlling individual test) to 20 per cent (significant individual test).

•

Further, access to the concessions is increased as the 50 per cent test was based on direct ownership of interests in a company or trust, whereas the new 20 per cent test incorporates both direct and indirect ownership of such interests.

•

There will be minimal administrative impacts on those impacted by the measure.

Clarification of exemptions from interest withholding tax

Schedule 2 to this Bill identifies those non-debenture debt interests eligible for exemption from interest withholding tax, for the purposes of sections 128F and 128FA of the Income Tax Assessment Act 1936. It also introduces regulation-making powers to prescribe further types of eligible debt interests and to exclude from exemption interest payments in certain circumstances.

Date of effect : The amendments limiting eligible debt interests to non-debenture debt interests that are non-equity shares will apply to debt interests issued on or after the date of the introduction of the Bill into the House of Representatives. The amendments establishing regulation-making powers will have effect from the date of Royal Assent.

Proposal announced : This measure has not previously been announced.

Financial impact : Nil.

Compliance cost impact : Negligible.

Streamline gift fund and integrity arrangements for deductible gift recipients

Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 to remove the requirement for certain deductible gift recipients (DGRs) to maintain a gift fund. It also amends the Taxation Administration Act 1953 to include improved integrity arrangements for DGRs listed in tax law.

These amendments allow the Commissioner of Taxation (Commissioner) to review whether a listed DGR in the tax law continues to be eligible to receive deductible gifts reflecting the Commissioner's current power to review the eligibility of endorsed DGR entities. As a further integrity measure these amendments require all DGRs to maintain adequate records.

Date of effect : This measure is to commence operation from the date of Royal Assent.

Proposal announced : The Government announced in the 2006-07 Budget two measures to further enhance philanthropy - removal of gift fund requirements for certain DGRs and to standardise compliance for DGRs.

Financial impact : Nil.

Compliance cost impact : Nil.

Deductible gift recipients

Schedule 4 to this Bill amends the Income Tax Assessment Act 1997 to extend the period for which deductions are allowed for gifts to certain funds that have time limited deductible gift recipient (DGR) status.

Date of effect : This Schedule extends the time period for deductions for gifts to the following organisations that are listed as DGRs:

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Dunn and Lewis Youth Development Foundation Limited until 31 December 2007;

•

The Rotary Leadership Victoria Australian Embassy for Timor-Leste Fund Limited until 31 December 2009;

•

St George's Cathedral Restoration Fund until 31 December 2007; and

•

St Michael's Church Restoration Fund until 23 February 2008.

Proposal announced : The extension of the tax deductibility of gifts to the Dunn and Lewis Youth Development Foundation Limited was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 077 of 30 October 2006.

The extension of the tax deductibility of gifts to The Rotary Leadership Victoria Australian Embassy for Timor-Leste Fund Limited was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 077 of 30 October 2006.

The extension of the tax deductibility of gifts to St George's Cathedral Restoration Fund was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 077 of 30 October 2006.

Financial impact : This measure will have these revenue implications:

Compliance cost impact : Nil.

Effective life of tractors and harvesters

Schedule 5 to this Bill amends the Income Tax Assessment Act 1997 to preserve the current period over which tractors and harvesters used in the primary production sector are depreciated.

Date of effect : These amendments will apply to a depreciating asset if the start time for the asset occurs on or after 1 July 2007.

Proposal announced : The proposal was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 083 of 16 November 2006.

Financial impact : Nil.

Compliance cost impact : Nil.

Farm management deposits

Schedule 6 to this Bill amends the Income Tax Assessment Act 1936 to increase the non-primary production income threshold and the total deposit limit for farm management deposits.

Date of effect : These amendments apply from the income year in which the amendments receive Royal Assent.

Proposal announced : These amendments were announced by the Minister for Agriculture, Fisheries and Forestry in Press Release No. DAFF 06/158PM of 24 October 2006.

Financial impact : This measure will have these revenue implications:

Compliance cost impact : This is expected to have a small transitional cost for the Australian Taxation Office, tax agents and software developers but no increase in ongoing compliance cost.

Capital protected borrowings

Schedule 7 to this Bill:

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amends the Income Tax Assessment Act 1997 to ensure that the capital protection on a capital protected borrowing is treated in the same way irrespective of whether the capital protection is provided explicitly - for example by an actual put option - or implicitly through the term of the arrangement; and

•

provides a transitional and a long-term methodology to determine the amount that is reasonably attributable to the cost of capital protection.

Date of effect : The interim methodology will apply to arrangements entered into, on or from 9.30 am, by legal time in the Australian Capital Territory, from 16 April 2003 to 30 June 2007. The long-term methodology will apply to arrangements entered into, from 1 July 2007.

Proposal announced : This measure was announced in the Treasurer's Press Release No. 19 of 16 April 2003. The details of the interim methodology were announced in the then Minister for Revenue and Assistant Treasurer's Press Release C045/03 of 30 May 2003.

Financial impact : The estimated cost to the revenue of determining the cost of capital protection by reference to the personal unsecured lending rate is expected to be nil over the forward years, as the personal unsecured lending rate was also used in the interim approach costing that is currently reported in the forward estimates.

Compliance cost impact : Compliance costs are expected to be lower for both issuers of, and investors in, capital protected borrowings.

Chapter 1 Small business CGT provisions

Outline of chapter

1.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997), the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax (Transitional Provisions) Act 1997 to reduce the compliance costs for small business and increase the availability of the small business capital gains tax (CGT) concessions.

1.2 These amendments also replace the controlling individual 50 per cent test with a significant individual 20 per cent test that can be satisfied either directly or indirectly through one or more interposed entities.

Context of amendments

1.3 Four small business CGT concessions are available for eligible small businesses:

•

the 15-year exemption;

•

the retirement exemption;

•

the active assets 50 per cent reduction; and

•

the small business roll-over.

1.4 The small business CGT concessions in their present form have applied since 21 September 1999. The concessions were introduced to further encourage investment in small business and assist small business taxpayers to provide for their retirement.

1.5 These amendments are in response to the recommendations made by the Board of Taxation in October 2005 (Post-implementation review of the quality and effectiveness of the small business capital gains tax concessions).

Summary of new law

1.6 A number of changes have been made to the small business CGT concessions to reduce the compliance costs for small business and increase the availability of the concessions.

1.7 The amendments will improve the operation of the small business CGT concessions by making changes to the maximum net asset value test, the active asset test, the 15-year exemption, the retirement exemption, the small business roll-over and how the concessions apply to partners in a partnership and deceased estates.

1.8 The controlling individual 50 per cent test is replaced by the new significant individual 20 per cent test. The test can be satisfied directly or indirectly through one or more interposed entities.

1.9 The significant individual 20 per cent test enables up to eight taxpayers to benefit from the full range of concessions (five taxpayers, or four taxpayers and their spouses) instead of the current limit of two controlling individuals or one controlling individual and their spouse.

1.10 Allowing the requirement to be satisfied either directly or indirectly, rather than just through direct interests as at present, has the additional advantage of assessing the real economic interests in the business.

Comparison of key features of new law and current law

Detailed explanation of new law

Significant individual test

1.11 An individual is a significant individual in a company or trust if they have a small business participation percentage in the company or trust of at least 20 per cent. [ Schedule 1, item 39, section 152-55 ]

1.12 The 20 per cent can be made up of direct and indirect percentages. [ Schedule 1, item 39, section 152-65 ]

1.13 An entity's direct small business participation percentage in a company is the percentage of:

•

voting power that the entity is entitled to exercise;

•

any dividend payment that the entity is entitled to receive; and

•

any capital distribution that the entity is entitled to receive.

[ Schedule 1, item 39, subsection 152-70(1 ), item 1 in the table ]

1.14 For a trust, where entities have entitlements to all the income and capital of the trust, an entity's direct small business participation percentage is the percentage of the income and capital of the trust that the entity is beneficially entitled to receive. [ Schedule 1, item 39, subsection 152-70(1 ), item 2 in the table ]

1.15 An entity's direct small business participation percentage in a trust, where entities do not have entitlements to all the income and capital of the trusts, if the trust made a distribution of income or capital, is the percentage of distributions of income and capital that the entity is beneficially entitled to during the income year. If the trust did not make a distribution of income or capital during the income year it will not have a significant individual during that income year. [ Schedule 1, item 39, subsection 152-70(1 ), item 3 in the table ]

1.16 If an entity has different percentages in a company, their participation percentage is the smaller or smallest percentage. The same applies for a trust. [ Schedule 1, item 39, subsection 152-70(1 )]

Example 1.1

Peter has shares that entitle him to 30 per cent of any dividends and capital distributions of Coffee Co. The shares do not carry any voting rights.

Peter's direct small business participation percentage in Coffee Co is zero per cent

1.17 An entity's indirect small business participation percentage in a company or trust is calculated by multiplying together the entity's direct participation percentage in an interposed entity, and the interposed entity's total participation percentage (both direct and indirect) in the company or trust. [ Schedule 1, item 39, section 152-75 ]

Example 1.2

Discretionary Trust owns 100 per cent of the shares in Operating Company; therefore Discretionary Trust has a 100 per cent direct interest (and no indirect interest) in Operating Company.

Anna receives 80 per cent of the distributions from Discretionary Trust; therefore she has a direct participation percentage of 80 per cent in Discretionary Trust.

To find Anna's participation percentage in Operating Company, multiply together Anna's direct participation percentage in Discretionary Trust and Discretionary Trust's total participation percentage in Operating Company.

80% x 100% = 80%


Anna has an 80 per cent participation percentage in Operating Company and is therefore a significant individual of Operating Company.

Bill receives 15 per cent of the distributions from Discretionary Trust; therefore he has a direct participation percentage of 15 per cent in Discretionary Trust.

To find Bill's participation percentage in Operating Company, multiply together Bill's direct participation percentage in Discretionary Trust and Discretionary Trust's total participation percentage in Operating Company.

15% x 100% = 15%


Bill has a 15 per cent participation percentage in Operating Company and is therefore not a significant individual of Operating Company.

(As a spouse of a significant individual with a participation percentage greater than zero in the entity, Bill will be a CGT concession stakeholder. See paragraph 1.23.)

Deborah receives 5 per cent of the distributions from Discretionary Trust; therefore she has a direct participation percentage of 5 per cent in Discretionary Trust.

To find Deborah's participation percentage in Operating Company, multiply together Deborah's direct participation percentage in Discretionary Trust and Discretionary Trust's total participation percentage in Operating Company.

5% x 100% = 5%


Deborah has a 5 per cent participation percentage in Operating Company and is therefore not a significant individual of Operating Company. (Deborah is not a CGT concession stakeholder. See paragraph 1.23.)

1.18 An indirect interest can be held through one or more interposed entities.

Example 1.3

Melissa's total small business participation percentage in Company C is the sum of her direct and indirect participation percentages (section 152-65).

Direct small business participation percentage in Company C

Melissa has a direct participation percentage in Company C of 10 per cent (section 152-70).

Indirect small business participation percentage in Company C

Because there are two interposed entities between Melissa and Company C, she will need to calculate the indirect small business participation percentage in respect of each interposed entity on the following basis.

First application : Melissa as the holding entity; Company A as the intermediate entity; and Company C as the test entity; and

Second application : Melissa as the holding entity; Company B as the intermediate entity; and Company C as the test entity (subsection-152-75(2)).

The indirect percentages Melissa has in Company C via Company A will need to be added to her indirect percentage in Company C via Company B to work out her total indirect percentage.

First application - Melissa's indirect percentage in Company C via interposed entity Company A

Melissa (holding entity) has a direct percentage in Company A (intermediate entity) of 50 per cent. This percentage is multiplied by the sum of Company A's direct and indirect percentage in Company C (test entity).

Company A has a direct percentage in Company C of zero per cent.

Company A has an indirect percentage in Company C of 20 per cent.

See below for how Company A's indirect percentage is worked out.

Therefore Melissa's indirect percentage in Company C via interposed entity Company A is:

50% x [0% + 20%] = 10 %


Alternatively this can be expressed as Melissa's direct percentage in Company A multiplied by the sum of Company A's direct percentage and indirect percentage in Company C.

Working out Company A's indirect percentage in Company C

To work out Company A's 20 per cent indirect percentage in Company C, we treat Company A as the holding entity, and Company B as the intermediate entity (subparagraph 152-75(1)(b)(ii)).

Company A's indirect small business participation percentage in Company C via interposed entity Company B is calculated as follows.

Company A (as holding entity) has a direct percentage of 50 per cent in Company B (the intermediate entity).

Company B (as intermediate entity) has a direct small business participation percentage in Company C of 40 per cent and a zero indirect percentage.

Therefore, Company A's indirect percentage in Company C is:

50% x [40% + 0%] = 20%


Alternatively this can be expressed as Company A's direct percentage in Company B multiplied by the sum of Company B's direct percentage and indirect percentage in Company C.

Second application - Melissa's indirect percentage in Company C via interposed entity Company B

Melissa (holding entity) has a direct percentage in Company B (intermediate entity) of 20 per cent. This amount is multiplied by the sum of Company B's direct and indirect percentage in Company C (test entity).

Company B has a direct percentage in Company C of 40 per cent.

Company B has an indirect percentage in Company C of zero per cent.

Therefore Melissa's indirect interest in Company C via interposed entity Company B is:

20% x [40% + 0%] = 8%


This is Melissa's direct percentage in Company B multiplied by the sum of Company B's direct percentage and indirect percentage in Company C.

Melissa's indirect small business participation percentage in Company C

Melissa's indirect small business participation percentage in Company C is 18 per cent. This is the sum of her indirect percentages in Company C via Company A and Company B.

Melissa's total small business participation percentage in Company C

Melissa's total small business participation percentage is the sum of her direct 10 per cent and indirect 18 per cent small business participation percentages in Company C (section 152-65).

As Melissa has a total small business participation percentage of 28 per cent she is a significant individual (section 152-55).

1.19 The small business concessions are intended for active participants in a small business, and the significant individual test represents a readily verifiable proxy for active participation. This reflects the fact that there is typically minimal separation between significant underlying ownership and management in small businesses. Put more simply, those who own a small business tend to run the business.

1.20 This amendment is in addition to those recommended by the Board of Taxation.

1.21 A number of amendments are made to reflect the replacement of the controlling individual test with the significant individual test. [ Schedule 1, items 18, 38 to 40, 43 to 45, 48 and 53, paragraph 152-5(c ), sections 152-50 and 152-100, paragraph 152-110(1)(d ), section 152-115, note to section 152-120, paragraph 152-305(2)(b ) and the example in subsection 152-315(5 )]

1.22 A number of amendments are made to reflect the possibility of having more than two CGT concession stakeholders because of the change to the significant individual test. [ Schedule 1, items 45, 52 and 54, paragraph 152-125(2)(b ), subsections 152-315(5 ) and 320(2 )]

CGT concession stakeholder

1.23 A person is a CGT concession stakeholder of a company or trust if they are a significant individual or the spouse of a significant individual with some participation percentage in the company or trust. This participation percentage can be held directly or indirectly through one or more interposed entities. The percentages are worked out in the same way as for the significant individual test. [ Schedule 1, item 39, section 152-60 ]

Maximum net asset value test

1.24 The maximum net asset value test allows the net asset value of an entity to be reduced by provisions for annual leave, long service leave, unearned income and tax liabilities. These amounts are not included as liabilities because they are not present legal obligations, but are relevant to the value of the business, having regard to commercial business valuation methods. This amendment addresses Recommendation 6.3 of the Board of Taxation report. [ Schedule 1, item 23, paragraph 152-20(1)(b )]

Example 1.4

Hanna has CGT assets with a value of $7.2 million, liabilities relating to the assets of $1.1 million and has made provisions for $100,000 of annual leave for her employees, $20,000 for unearned income and $50,000 for tax liabilities for the financial year. Hanna has a net asset value of $5.93 million.

1.25 The maximum net asset value test takes into account the net assets of a taxpayer, as well as the net assets of connected entities and small business affiliates (subject to certain exclusions). The net assets calculation allows an entity to have a negative net asset value, and for that to be taken into account in determining if another entity satisfies the test. This amendment addresses Recommendation 6.2 of the Board of Taxation report. [ Schedule 1, item 23, subsection 152-20(1 )]

Example 1.5

Ice Cream Co has CGT assets with a value of $2 million and liabilities relating to those assets of $3 million. Ice Cream Co has a net asset value of negative $1 million.

From Example 1.4, Hanna owns 70 per cent of the shares of Ice Cream Co and Ice Cream Co is a connected entity. Net asset value includes the value of connected entities, therefore Ice Cream Co's net asset value is included in Hanna's net asset value. Hanna's net asset value is reduced by $1 million to $4.93 million.

1.26 The maximum net asset value test, when applied in relation to partnership assets, only counts the assets of each relevant partner and not the assets of the partnership as a whole. This is achieved by repealing subsection 152-15(2). This amendment addresses Recommendation 6.8 of the Board of Taxation report. [ Schedule 1, item 22, section 152-15 ]

Example 1.6

Dan is a partner in an accounting firm. The firm has net assets of $10 million and Dan has a 20 per cent stake in the partnership. The partnership sells the building from which it operates. In applying the net asset test, Dan only includes $2 million in net assets in relation to his interest in the partnership.

1.27 A person is not automatically another person's small business CGT affiliate because of a business relationship. For example, co-directors, co-trustees or partners are not necessarily affiliates. Nor are directors automatically affiliates of the company, nor the company an affiliate of them. This amendment addresses Recommendations 6.6 and 6.7 of the Board of Taxation report. [ Schedule 1, item 28, subsection 152-25(2 )]

Example 1.7

Tom and Bob are both directors of Import Company. They do not have any relationship outside the company. Tom and Bob will not be small business CGT affiliates because of their co-directorship of Import Company.

Example 1.8

Chris and Melanie are both trustees of the Export Trust which runs a family business. They are not necessarily small business CGT affiliates because they are trustees of the same trust. However, it is necessary to apply the test of whether one of them acts, or could be expected to act, in concert with the other.

1.28 An individual only includes in their net assets the current market value of a dwelling to the extent that it is reasonable, having regard to the amount that the dwelling has been used to produce assessable income which gives rise to deductions for interest payments. This amendment addresses Recommendation 6.9 of the Board of Taxation report. [ Schedule 1, item 26, subsection 152-20(2A )]

1.29 If the dwelling has never had any income producing use, the value is not included at all. [ Schedule 1, item 25, subparagraph 152-20(2)(b)(ii )]

1.30 If the dwelling has had some income producing use, the percentage of income producing use is multiplied by the current market value to work out the value of the dwelling that should be included. This will take into account the length of time and percentage of income producing use of the dwelling.

Example 1.9

Ben owns a house that has a market value of $750,000 just before applying the net assets test. Ben owned the house for 12 years - for the first three years, 20 per cent of it was used for producing assessable income, for the following two years it was used 40 per cent for producing assessable income, for two years it was used solely as a main residence and for the last five years it was used 10 per cent for producing assessable income.

Ben's dwelling has had 15.8 per cent income producing use (3/12 x 20%) + (2/12 x 40%) + (2/12 x 0%) + (5/12 x 10%).

Ben will include $118,750 in his net asset test ($750,000 x 15.8%).

Ben has a liability of $500,000 attached to the house. Therefore 15.8 per cent ($79,166) of the liability is also included in the net asset test.

1.31 The rules in the net asset test for dwellings also apply to land that would be included for the purpose of the main residence exemption under section 118-120. This exemption allows up to two hectares of land that is adjacent to the dwelling, to the extent that the land is used primarily for private or domestic purposes. This amendment is in addition to those recommended by the Board of Taxation. [ Schedule 1, item 25, subparagraph 152-20(2)(b)(ii )]

1.32 When working out whether or not a taxpayer exceeds the $5 million net asset value test, the taxpayer takes into account assets of an entity connected with them that are used in the entity's business. However, the taxpayer does not take into account such assets if the entity is connected with the taxpayer just because another entity is the taxpayer's small business CGT affiliate. This amendment does not change the law; it rewrites the provisions to make them clearer. This amendment addresses Recommendation 6.10 of the Board of Taxation report. [ Schedule 1, item 27, subsections 152-20(3 ) and ( 4 )]

Active asset test

1.33 An asset that was owned for less than 15 years will satisfy the active asset test provided that it was active for periods totalling half the relevant period. The relevant period is from when the asset is acquired until the CGT event. If the business ceases within the 12 months before the CGT event (or such longer time as the Commissioner of Taxation (Commissioner) allows) the relevant period is from acquisition until the business ceases. [ Schedule 1, item 31, subsections 152-35(1 ) and ( 2 )]

1.34 The asset no longer has to be active just before the CGT event. This is achieved by repealing subparagraph 152-35(a)(i). [ Schedule 1, item 31, section 152-35 ]

Example 1.10

Jodie ran a florist business from a shop that she has owned for eight years. She ran the business for five years, and then leased it to an unrelated party for three years before selling. The shop satisfies the active asset test because it was actively used in Jodie's business for more than half the period of ownership - even though the property was not used in the business just before it was disposed of.

1.35 If an asset is owned for more than 15 years, it need only be active for periods totalling at least 71/2 years during the relevant period. [ Schedule 1, item 31, subsections 152-35(1 ) and ( 2 )]

Example 1.11

Alice ran a farming business on a property that she has owned for 17 years. She ran the farm for three years, and then leased it to an unrelated party for five years. She then ran the farm for another five years before retiring and leasing the farm for another four years before selling it. The farm satisfies the active asset test because it was actively used in Alice's farming business for at least 71/2 years - even though the period was not continuous and the property was not used in the business just before it was disposed of.

1.36 This amendment addresses Recommendation 7.1 of the Board of Taxation report, with minor modifications that favour the taxpayer.

1.37 There are alternative requirements that can be met for an asset to be an active asset. An asset is active if it is used, or held ready for use, in carrying on a business by the taxpayer, the taxpayer's small business CGT affiliate or a connected entity - this can apply to both tangible and intangible assets. [ Schedule 1, item 32, paragraph 152-40(1)(a )]

1.38 An intangible asset is also active if the taxpayer owns it and it is inherently connected with a business that the taxpayer, a small business CGT affiliate, or another connected entity, carries on. This is an alternative test for intangible assets, because it will be difficult for some intangible assets to meet the requirement that it is used, or held ready for use, in carrying on a business - for example, goodwill is not 'used' in a business, but is inherently connected with it. This amendment addresses Recommendation 7.4 of the Board of Taxation report. [ Schedule 1, item 32, paragraph 152-40(1)(b )]

1.39 To find out whether a share in a company or an interest in a trust is an active asset, it is necessary to 'look through' the company or trust and establish whether 80 per cent of the company or trust's assets are active. Cash and financial instruments are not active assets, but they count towards the satisfaction of the 80 per cent test provided that they are inherently connected with the business. This amendment addresses Recommendation 7.5 of the Board of Taxation report. [ Schedule 1, item 33, subparagraphs 152-40(3)(b)(ii ) and ( iii )]

1.40 Existing subparagraph 152-40(3)(b)(ii), which allows capital proceeds held to acquire new active assets to count towards satisfaction of the 80 per cent test, is no longer necessary because the new inclusions for cash and financial instruments covers such capital proceeds.

1.41 Applying the 80 per cent test on a continuous basis can impose an onerous compliance requirement on small business. Taxpayers are not required to continually apply the 80 per cent test if the test has been passed at some stage and there is no reason to think that the test will be failed at the later time. An example of when it will be reasonable to think that the share or trust interest is still an active asset is when there have been no significant changes to the assets or liabilities of the company or trust. This amendment addresses Recommendation 7.6 of the Board of Taxation report. [ Schedule 1, item 35, subsection 152-40(3A )]

1.42 If there have been significant changes and the 80 per cent test is reapplied and is not met, the share or trust interest will still be an active asset provided that the failure of the test is only temporary. This amendment addresses Recommendation 7.6 of the Board of Taxation report. [ Schedule 1, item 35, paragraph 152-40(3B )]

Example 1.12

John sells an active asset, meets the basic conditions and makes a capital gain of $500,000. He acquires shares in Fruit and Veg Co, which runs his family business, as replacement assets. The shares in Fruit and Veg Co meet the 80 per cent test and thus are active assets. Some time later, Fruit and Veg Co borrows money to pay a dividend, and fails the 80 per cent test. Two weeks later the dividend is paid and the shares pass the 80 per cent test again. For the two weeks, the shares are treated as active assets even though they do not pass the 80 per cent test.

Example 1.13

Georgina buys shares in a company that buys a property in order to start a farm. The property makes up 50 per cent of the asset value of the company. For the first year that she owns the shares, the company does not actively use the property. After that time, the company starts the farming business. The property is not active for the first year therefore the company does not pass the 80 per cent test. The shares are not treated as active because the company failed the 80 per cent test for an extended period of time (not just a temporary failure).

1.43 Shares in widely held companies cannot be active assets, even if they pass the 80 per cent test, unless they are held by a CGT concession stakeholder of the company. The same rule applies to trusts that are similar to widely held companies. This amendment addresses Recommendation 7.7 of the Board of Taxation report. [ Schedule 1, item 36, subparagraphs 152-40(4)(b)(i ) and ( c)(i )]

1.44 Trusts that are similar to widely held companies are trusts that are listed on an approved stock exchange, or the trust has more than 50 members (other than a discretionary trust). However, there are exceptions for trusts with 20 members or less, that between them, either:

•

hold at least 75 per cent of the value of the membership interests in the trust;

•

are capable of controlling at least 75 per cent of the trust voting interests; or

•

received at least 75 per cent of the distributions made by the trustee during the year.

[ Schedule 1, item 37, subsection 152-40(5 )]

1.45 When an asset is owned by a discretionary trust but is used in carrying on a business by another entity, that other entity must be connected with the discretionary trust in order for the asset to satisfy the active asset test. The other entity would be connected with the discretionary trust if, for example, it controlled the discretionary trust.

1.46 An entity is treated as controlling a discretionary trust in any income year if, for any of the four preceding income years, the entity and/or its affiliates received at least 40 per cent of any income or capital distributed by the trustee. This does not change the law; it clarifies that the test can be applied to any income year, rather than just the current one. This amendment is in addition to those recommended by the Board of Taxation. [ Schedule 1, item 29, subsection 152-30(5 )]

1.47 The trustee of a discretionary trust can nominate up to four beneficiaries as controllers of the trust for an income year where the trust had no taxable income or a tax loss. This amendment is in addition to those recommended by the Board of Taxation. [ Schedule 1, item 30, subsection 152-30(6A )]

Additional requirement for shares in companies and interests in trusts

1.48 In addition to the other basic requirements, if the CGT event happens to a share in a company or an interest in a trust, one of two additional basic conditions must be satisfied just before the CGT event.

1.49 The first requirement is that the entity making the capital gain on the shares or trust interests is a CGT concession stakeholder in the company or trust. This test already exists under existing paragraph 152-10(2)(b). [ Schedule 1, item 20, paragraph 152-10(2)(a )]

1.50 The alternative requirement is the 90 per cent test. This test only applies if there is an interposed entity between the CGT concession stakeholder and the company or trust in which the shares or interests are held. The interposed entity satisfies the test if 90 per cent of the participation percentages in that entity are held by CGT concession stakeholders of the company or trust in which the shares or interests are held. [ Schedule 1, item 20, paragraph 152-10(2)(b )]

Example 1.14

From Example 1.2:

Anna, a significant individual and a CGT concession stakeholder of Operating Company, has an 80 per cent small business participation percentage in Discretionary Trust.

Bill, a CGT concession stakeholder of Operating Company, has a 15 per cent small business participation percentage in Discretionary Trust.

Deborah, who is not a CGT concession stakeholder of Operating Company, has a 5 per cent small business participation percentage in Discretionary Trust.

At least 90 per cent of the participation percentages in the Discretionary Trust are held by CGT concession stakeholders of Operating Company. Therefore Discretionary Trust satisfies the ownership requirement if it sells its shares in Operating Company and can access the concessions on those shares, provided that the other conditions are met

1.51 As with the significant individual test, the participation percentage can be held directly or indirectly through multiple interposed entities.

Example 1.15

The discretionary trust sells the units in the Unit Trust.

Catherine, a significant individual and a CGT concession stakeholder of Unit Trust, has a 72 per cent participation percentage in Discretionary Trust.

If the other interests in Discretionary Trust are held by people who are not CGT concession stakeholders, Discretionary Trust will not satisfy the ownership requirement and will not be able to access the concessions.

1.52 The existing requirement in paragraph 152-10(2)(a) that the company or trust have a controlling individual is removed because the company or trust will always have a controlling individual (now significant individual) if the other additional conditions are met.

1.53 These amendments are in addition to those recommended by the Board of Taxation. [ Schedule 1, item 20, section 152-10 ]

15-year exemption

1.54 For an individual to access the 15-year exemption on shares in companies or interests in trusts, one condition is that the company or trust must have had a significant individual for periods totalling at least 15 years during which the individual owned the shares or trust interests. It does not need to be the same significant individual at all times. This amendment addresses Recommendation 10.2 of the Board of Taxation report, with minor modifications that favour the taxpayer. [ Schedule 1, item 41, paragraph 152-105(c )]

Example 1.16

Julie owned 10 per cent of the shares in Juice Company for 18 years from 1987 to 2005. For five years (1987 to 1992) she owned another 10 per cent and was a significant individual. For a different 10 years (1995-2005), another person (Edward) was a significant individual. The significant individual requirement is met for Julie's shares.

1.55 For a company or trust to access the 15-year exemption on assets it owns, there must have been a significant individual for at least 15 of the years they owned the asset. This amendment addresses Recommendation 10.2 of the Board of Taxation report, with minor modifications that favour the taxpayer. [ Schedule 1, item 42, paragraph 152-110(1)(c )]

Example 1.17

From Example 1.16, Juice Company had a factory for the last 18 years. Julie was a significant individual for five years and Edward was a significant individual for 10 years. Juice Company will satisfy the significant individual requirement in relation to the factory.

1.56 In a year that a discretionary trust has no taxable income, or a tax loss, and did not make a distribution of income or capital it is treated as having met the significant individual requirement. [ Schedule 1, item 45, section 152-120 ]

1.57 When the company or trust is eligible for the 15-year exemption, payments that relate to that exempt amount are disregarded in the hands of the CGT concession stakeholder that ultimately receives the amount, and any interposed entity that facilitates the payment of the amount. This applies to the extent that the payments are equal to or less than the stakeholders participation percentage (this was previously called the stakeholders control percentage). [ Schedule 1, item 45, subsection 152-125(2 )]

1.58 The stakeholder's participation percentage for a company or a trust is the person's small business participation percentage. However, the stakeholder's participation percentage for a trust, where entities do not have entitlements to all the income and capital of the trust, is 100 per cent divided by the number of CGT concession stakeholders. [ Schedule 1, item 45, paragraphs 152-125(2)(a ) and ( b )]

1.59 A payment that is disregarded under the 15-year exemption will have no other tax consequences - it will not constitute a dividend and will not be a frankable distribution. This amendment addresses Recommendation 10.3 of the Board of Taxation report. [ Schedule 1, items 45 and 58, subsection 152-125(3 ), paragraph 202-45(j )]

1.60 The payment will not cause CGT event G1 (capital payments for shares where the payment is not assessable) to happen. This amendment is in addition to those recommended by the Board of Taxation. [ Schedule 1, item 11, paragraph 104-135(1A)(c )]

1.61 A payment relates to the exempt amount to the extent that it represents a distribution of the capital gain. It is not intended that other payments, such as salary, fringe benefits, repayments of loans, dividends or eligible termination payments, should have different consequences for CGT concession stakeholders than they otherwise would. This amendment addresses Recommendation 10.3 of the Board of Taxation report. [ Schedule 1, item 45, paragraph 152-125(1)(b )]

1.62 There is a requirement that the company or trust make the payments relating to the exempt amount within two years of the CGT event. To take into account actual taxpayer circumstances and commercial practices, the Commissioner has a discretion to extend this time limit. This amendment addresses Recommendation 10.4 of the Board of Taxation report. [ Schedule 1, item 45, subsection 152-125(4 )]

Retirement exemption

1.63 Payments made by a company or trust to an employee of an amount exempted under the retirement exemption are deemed to be payments in respect of the termination of employment of the employee. There is no need for an actual termination of employment. [ Schedule 1, item 55, paragraph 152-325(7)(a )]

1.64 If the payment is made by a private company to a shareholder, the payment can constitute excessive remuneration under section 109 of the ITAA 1936.

1.65 Payments made by a company or trust to a non-employee of an amount exempted under the retirement exemption are deemed to be an eligible termination payment. [ Schedule 1, item 55, paragraph 152-325(7)(b )]

1.66 This amendment addresses Recommendation 12.1 of the Board of Taxation report.

1.67 One requirement of the retirement exemption is that, if the person is less than 55 years old, a payment of the amount exempted must be made to a superannuation fund. For an individual making the gain, the relevant time at which the person must be 55 or over is the time that the choice is made, rather than at the time that capital proceeds are received. This ensures that the amount is not required to be rolled over into a superannuation fund because the person was less than 55 at the time capital proceeds were received, but 55 or over by the time the choice to use the retirement exemption is made (generally on lodgement of the relevant income tax return). This amendment addresses Recommendation 12.2 of the Board of Taxation report. [ Schedule 1, item 47, paragraph 152-305(1)(b )]

Example 1.18

Jamie sells his factory, satisfies the basic conditions and makes a capital gain of $400,000. Jamie is aged 54 when he receives capital proceeds from the sale. He had not decided what to do with the money at that time. Jamie turns 55 years of age, and decides when lodging his income tax return, that he wants to use the retirement exemption - he is not required to pay the money into a superannuation fund because he was aged 55 just before he made the choice.

1.68 If an individual receives capital proceeds in instalments, each instalment is treated as a separate payment. This means that each instalment is looked at separately and in succession in applying the exemption up to the individual's CGT exempt amount. [ Schedule 1, items 49 and 55, subsections 152-310(3 ) and 325(2 )]

1.69 In order to access the retirement exemption on a capital gain made by a company or trust, the company or trust must make a payment of the amount to at least one of its CGT concession stakeholders. [ Schedule 1, item 55, subsection 152-325(1 )]

1.70 If the company or trust receives more than one amount of capital proceeds, the first instalment needs to be fully paid out where the amount of that instalment is less than the CGT exempt amount. Subsequent instalments must be compared with the CGT exempt amount, as reduced by any earlier payments made from previous instalments. [ Schedule 1, items 49 and 55, subsections 152-310(3 ) and 325(2 )]

1.71 It is not necessary to receive actual capital proceeds in order to access the retirement exemption - the retirement exemption is available where a capital gain is made when an active asset is gifted and the market value substitution rule has applied or where CGT event J2, J5 or J6 happens. This is achieved by repealing subsections 152-310(3) and 325(4). [ Schedule 1, item 17, subsection 116-30(1 )]

1.72 Therefore if the individual disposing of the asset is aged 55 or over, they can use the retirement exemption if they meet the basic conditions. If they are less than 55, they can access the retirement exemption provided that they meet the basic conditions and pay an amount equal to the disregarded capital gain into a superannuation fund. In order to access the exemption on a gain made by a company or trust for which there are no actual proceeds, the company or trust must make a payment of the disregarded capital gain to at least one of its CGT concession stakeholders. This amendment is in addition to those recommended by the Board of Taxation.

Example 1.19

Amber, a farmer aged 52, decided that she wanted to give her farm to her son Frank. She made a capital gain of $150,000 on the gift of the asset to Frank. Provided that Amber meets the basic conditions, she can put $150,000 into a superannuation fund and use the retirement exemption to disregard the capital gain. (If Amber was 55 or over she would not need to pay the amount into a superannuation fund to gain access to the retirement exemption.)

Example 1.20

In 1999, Amanda sold the shop where she operated her hairdressing business in order to move to larger premises, and disregarded the capital gain of $250,000 under the small business roll-over. She purchased new premises as a replacement asset. In 2005, Amanda ceased operating the hairdressing business; the premises stopped being an active asset and CGT event J2 happened. There are no capital proceeds from this event; however Amanda, aged 45, can access the retirement exemption on the capital gain, provided that she makes a payment equal to the amount of the capital gain into a superannuation fund. (If Amanda was 55 or over, it would not be necessary to make a payment into a superannuation fund.)

Small business roll-over

1.73 The small business roll-over is available for capital gains from a CGT event if the basic conditions for relief are met. A replacement asset need not be acquired, or expenditure does not need to be incurred to improve an asset, before choosing the roll-over. This amendment and the inclusion of CGT events J5 and J6 (see below) address Recommendation 13.5 of the Board of Taxation report. [ Schedule 1, item 57, section 152-410 ]

1.74 If a taxpayer chooses the roll-over, they can disregard all or part of the gain. This amendment addresses Recommendation 13.3 of the Board of Taxation report. [ Schedule 1, item 57, section 152-415 ]

1.75 Certain CGT events will happen if, by the end of two years after the capital gain was made, there are no replacement assets; if sufficient expenditure on replacement assets is not incurred; or if the assets do not meet certain criteria. A CGT event can happen after that period if there were replacement assets at the end of the period and a change happens in respect of the replacement asset after the end of the period.

1.76 Replacement assets can be newly acquired or improvements to an asset a taxpayer already owns. This amendment addresses Recommendation 13.4 of the Board of Taxation report. [ Schedule 1, items 12 and 13, paragraphs 104-185(1)(a ), 197(1)(a ) and 198(1)(a )]

CGT event J5

1.77 CGT event J5 will happen two years after the last CGT event in the year in which the roll-over is chosen if there are no replacement assets. [ Schedule 1, item 13, paragraph 104-197(1)(a ) and subsection 104-197(3 )]

1.78 CGT event J5 will also happen if a replacement asset does not meet certain conditions. It must be active at the end of that period. [ Schedule 1, item 13, paragraph 104-197(2)(a )]

1.79 Also, if the asset is a share in a company or an interest in a trust, the asset must be owned by either:

•

a CGT concession stakeholder of the company or trust [ Schedule 1, item 13, subparagraph 104-197(2)(b)(i )];

•

an entity connected with a CGT concession stakeholder [ Schedule 1, item 13, subparagraph 104-197(2)(b)(i )]; or

•

a company or trust that meets the 90 per cent test (see paragraph 1.50) [ Schedule 1, item 13, subparagraph 104-197(2)(b)(ii )],

at the end of that period.

1.80 The first two dot points previously required a controlling individual rather than a CGT concession stakeholder. This amendment addresses Recommendation 13.7 of the Board of Taxation report.

1.81 The capital gain is the amount of the previous capital gain that was rolled over. [ Schedule 1, item 13, subsection 104-197(4 )]

Example 1.21

In 2004, Jennifer makes a capital gain of $80,000 on an active asset and meets the maximum net asset value test. Jennifer disregards the whole capital gain under the small business roll-over.

In 2006, Jennifer does not have any replacement assets by the end of the two-year period. CGT event J5 happens and Jennifer makes a capital gain of $80,000.

Example 1.22

In 2004, Anthony makes a capital gain of $50,000 on an active asset and meets the maximum net asset value test. Anthony disregards the whole capital gain under the small business roll-over.

In 2005, Anthony spends $50,000 on improving an asset. However, the asset is not active at the end of two years from the CGT event.

In 2006, Anthony does not have any other replacement assets. CGT event J5 happens and Anthony makes a capital gain of $50,000.

1.82 The Commissioner can extend the two-year time limit for CGT event J5. This amendment addresses Recommendation 13.1 of the Board of Taxation report. [ Schedule 1, items 12 and 13, section 104-190, subsection 104-197(5 )]

CGT event J6

1.83 CGT event J6 will happen two years after the last CGT event in the year the roll-over is chosen if there has been insufficient expenditure on the replacement asset or assets that met certain conditions (eg, the replacement asset is the taxpayer's active asset at the end of the two year period). [ Schedule 1, item 13, subsection 104-198(2 )]

1.84 Expenditure is insufficient if the relevant expenditure is less than the amount of the capital gain that is rolled over. The relevant expenditure is made up of:

•

the costs that would be included in the first element of cost base of a replacement asset;

•

the incidental costs of acquisition of a replacement asset; and

•

the costs that would be included in the fourth element of cost base of a replacement asset,

where the replacement asset met the required conditions. [ Schedule 1, item 13, paragraph 104-198(1)(d ]

1.85 The capital gain is the difference between the original capital gain that was rolled over and the amount of expenditure incurred. [ Schedule 1, item 13, subsection 104-198(3 )]

Example 1.23

In 2004, Abby makes a capital gain of $700,000 on an active asset and meets the maximum net asset value test. Abby chooses to disregard the whole capital gain.

In 2005, Abby purchased new business premises for $300,000 and spent $150,000 on improving some other assets. The replacement assets meet all of the relevant conditions.

However, the amount of expenditure on the replacement assets is only $450,000. The capital gain that was rolled over was $700,000.

In 2006, two years after the original CGT event, CGT event J6 happens because there has been insufficient expenditure and Abby makes a capital gain of $250,000. The roll-over of $450,000 of the original capital gain continues.

1.86 The Commissioner can extend the two-year time limit for CGT event J6. This amendment addresses Recommendation 13.1 of the Board of Taxation report. [ Schedule 1, items 12 and 13, section 104-190 and subsection 104-198(4 )]

CGT event J2

1.87 CGT event J2 can happen when a person has chosen the small business roll-over and has acquired replacement assets that meet the following tests:

•

the asset is acquired or improved in the period starting one year before and ending two years after the last CGT event in the year of income in which the roll-over is chosen [ Schedule 1, item 12, paragraph 104-185(1)(a )];

•

the asset is active at the end of that same period [ Schedule 1, item 12, paragraph 104-185(1)(b )]; and

•

the owner of the asset is one of the following:

•

a CGT concession stakeholder of the company or trust [ Schedule 1, item 12, subparagraph 104-185(1)(c)(i )];

•

an entity connected with a CGT concession stakeholder [ Schedule 1, item 12, subparagraph 104-185(1)(c)(i )]; or

•

a company or trust that meets the 90 per cent test (see paragraph 1.50) [ Schedule 1, item 12, subparagraph 104-185(1)(c)(ii )].

1.88 CGT event J2 happens when there is a change in relation to a replacement asset of the kind that previously caused CGT event J2 or former CGT event J3 to happen. [ Schedule 1, item 12, subsections 104-185(2 ) and ( 3 )]

1.89 Because of the need to integrate the replacement asset conditions previously in Subdivision 152-E into the CGT events, and to ensure that the events interact appropriately, CGT events J2 and J3 are integrated into a single CGT event. Section 104-190 (CGT event J3) is repealed. [ Schedule 1, item 12, section 104-185 ]

1.90 CGT event J2 can only happen after the end of the replacement asset period. [ Schedule 1, item 12, paragraph 104-185(1)(d )]

1.91 CGT event J2 will not happen to shares and trust interests when the owner of the share or trust interest stops being:

•

a CGT concession stakeholder of the company or trust;

•

an entity connected with a CGT concession stakeholder; or

•

a company or trust that meets the 90 per cent test (see paragraph 1.50),

provided that the owner continues to be one of those things listed.

[ Schedule 1, item 12, paragraphs 104-185(1)(c ) and ( 3)(b )]

Example 1.24

Company A acquires shares in Company B as a replacement asset. Company A is connected to Megan who is a CGT concession stakeholder in Company B.

Megan sells her shares in Company B and is no longer a CGT concession stakeholder in Company B.

However, Company A is 100 per cent owned by Beth, who is a CGT concession stakeholder in Company B. Company A is connected with Beth and is 90 per cent owned be CGT concession stakeholders of Company B.

CGT event J2 does not happen when Megan sells her shares.

1.92 If there was only one replacement asset, or if a change happens to all of the replacement assets, the capital gain is the amount that was originally rolled over. [ Schedule 1, item 12, paragraphs 104-185(5)(a ) and ( b )]

1.93 If there was more than one replacement asset and a change happens to less than all of the assets, the capital gain is the difference between the amount that was originally rolled over and the relevant expenditure on the remaining replacement assets that satisfied relevant conditions. [ Schedule 1, item 12, paragraph 104-185(5)(c )]

1.94 If CGT event J6 had previously happened in relation to the roll-over, the capital gain is the same as calculated above, less the capital gain previously made under CGT event J6. [ Schedule 1, item 12, subsection 104-185(6 )]

1.95 If CGT event J2 had previously happened in relation to the roll-over, the capital gain is the same as calculated above, less the capital gain previously made under CGT event J2. [ Schedule 1, item 12, subsection 104-185(7 )]

1.96 If CGT events J6 and J2 have both previously happened in relation to the roll-over, the capital gain is the same as calculated above, less the capital gains previously made under CGT events J6 and J2. [ Schedule 1, item 12, subsection 104-185(7 )]

Example 1.25

From Example 1.23, Abby's new business premises ceased being active after five years. CGT event J2 will happen raising a capital gain of $300,000.

$700,000 (the original capital gain rolled over); less

$250,000 (the capital gain previously made under CGT event J6); less

$150,000 (the relevant expenditure on the remaining active replacement assets).

The roll-over of $150,000 of the original capital gain (which equates to the amount spent on improving the other assets, which are the only replacement assets that remain active) continues.

After another two years, the improved assets cease being active, CGT event J2 will happen again raising a capital gain of $150,000.

$700,000 (the original amount rolled over); less

$250,000 (the gain previously made under CGT event J6); less

$300,000 (the gain previously made under CGT event J2); less

$0 (the relevant expenditure on the remaining replacement assets that satisfy the relevant conditions).

1.97 In order to ensure that the small business roll-over works appropriately for the time before these amendments apply, a transitional provision provides that a taxpayer would not have to return a capital gain in the year of disposal:

•

It also ensures that the taxpayer (if they did not subsequently acquire a replacement asset) is not precluded from accessing the retirement exemption on the capital gain (ie, if a replacement asset was not acquired, it would be as though the roll-over never happened).

•

It allows for the amendment of assessments if:

•

a replacement asset was never acquired and the retirement exemption did not reduce the capital gain to nil; or

•

a capital gain was returned in the year of disposal, and the time in which the taxpayer could acquire a replacement asset has not expired.

[ Schedule 1, item 67, Division 152 of the Income Tax ( Transitional Provisions ) Act 1997 ]

Deceased estates

1.98 When an individual dies, their legal personal representative or beneficiary can access the concessions - to the extent that the deceased would have been able to access them just before they died - if a CGT event happens to the assets in the hands of the legal personal representative or beneficiary within two years of the death of the individual. This amendment addresses Recommendation 13.8 of the Board of Taxation report. [ Schedule 1, item 39, subsections 152-80(1 ) and ( 2 )]

1.99 The Commissioner can extend the two year period. [ Schedule 1, item 39, subsection 152-80(3 )]

1.100 If the deceased met the basic conditions just before death the active asset 50 per cent reduction, the small business roll-over, and / or the retirement exemption can be accessed. [ Schedule 1, item 39, paragraph 152-80(1)(c )]

1.101 For the retirement exemption, there is no need for the amount to be paid into a superannuation fund, even if the deceased was less than 55 years of age just before their death. This reflects the likely outcome if the deceased had disposed of the asset before death and paid the amount into a superannuation fund. The amount would be released to beneficiaries after death. [ Schedule 1, item 39, paragraph 152-80(2)(b )]

1.102 In order to access the 15-year exemption, the deceased would have to have met the additional requirements in section 152-105 just before death. However, the requirement that the CGT event happens in relation to the retirement of the individual does not need to be met. [ Schedule 1, item 39, paragraph 152-80(2)(a )]

Application and transitional provisions

1.103 These amendments apply to CGT events happening in the 2006-07 and later income years.

1.104 This means that some of the new tests will apply to time periods before the 2006-07 income year if the relevant CGT event happens after that time. For example, if a CGT event happens after the application of these amendments, a company or trust that wants to access the 15-year exemption will only need to have had a significant individual in earlier years, not a controlling individual. Also, the amendments described in paragraph 1.97 will apply to CGT events that happened in the 2005-06 income year or an earlier income year.

Consequential amendments

1.105 A number of amendments are made to allow capital gains to be rolled over against expenditure on capital improvements as well as acquisitions of replacement assets. [ Schedule 1, items 9, 12 and 56, sections 104-5, 104-185, 104-190, 152-400 ]

1.106 A number of amendments are made to reflect the removal of the requirement that payments be eligible termination payments in order to access the retirement exemption. [ Schedule 1, items 1, 2, 46 and 51, paragraph 27A(1)(jaa ) and subsection 140M(6 ) of the ITAA 1936, note to section 152-220, subsection 152-310(5 )]

1.107 A number of amendments are made to reflect the inclusion of CGT events J5 and J6. [ Schedule 1, item 3 subsection 102-5(1 ), items 6 and 7, paragraphs 103-25(3)(b ) and ( c ), item 10, section 104-5, item 19, section 152-5, item 21 and subsection 152-10(4 )

1.108 A number of amendments are made to reflect the removal of CGT event J3. [ Schedule 1, item 4, subsection 102-25(2 ), item 5, subsection 102-25(2A ), item 8, section 104-5, item 16, paragraph 115-25(3)(hb ), item 15, section 112-115, item 19, section 152-5, item 21, subsection 152-10(4 )]

1.109 Some definitions are added to and removed from the Dictionary. [ Schedule 1, items 59 to 64, subsection 995-1(1 )]

REGULATION IMPACT STATEMENT - for the significant individual test

Policy objective

1.110 The controlling individual test in the small business CGT concessions can be onerous to satisfy for some small businesses (eg, if a business has three equal owners, there is no controlling individual), and can exclude businesses that would be able to access the concessions, but for the structure of that business (eg, if the business is run by an individual with a 100 per cent stake but through a tiered ownership structure, there may be no controlling individual).

1.111 The objective is to make the controlling individual test less onerous so that the small business CGT concessions can be accessed by a broader range of small business taxpayers.

Implementation options

Option 1: replacing the current controlling individual test with a (new) significant individual test (direct ownership only, as at present)

1.112 This option is to replace the current controlling individual (50 per cent) test with a significant individual test, with a reduced percentage interest of:

•

a) 33? per cent (this option would enable up to four taxpayers to benefit from the full range of concessions (three taxpayers, or two taxpayers and their spouses));

•

b) 25 per cent (this option would enable up to six taxpayers to benefit from the full range of concessions (four taxpayers, or three taxpayers and their spouses), providing other requirements are satisfied);

•

c) 20 per cent (this option would enable up to eight taxpayers to benefit from the full range of concessions (five taxpayers, or four taxpayers and their spouses), providing other requirements are satisfied); or

•

d) 10 per cent (this option would enable up to 18 taxpayers to benefit from the full range of concessions (10 taxpayers, or nine taxpayers and their spouses), providing other requirements are satisfied).

Option 2: replacing the current controlling individual test with a (new) significant stake test (direct or indirect ownership)

1.113 Same as above (Options (a) to (d)) except that the test would also allow the relevant percentage of ownership to be satisfied either directly or indirectly through one or more interposed entities, rather than just through direct ownership as under the controlling individual test.

Option 3: combining the interests of close family members

1.114 Another option is to allow the existing controlling individual test to be satisfied by combining the interests of close family members.

Assessment of impacts of each implementation option

Impact group identification

1.115 The taxpayers who are affected are small business taxpayers who carry on a business via a company or trust who cannot currently access the small business CGT concessions, and the spouses of small business taxpayers who would qualify as CGT concession stakeholders will be affected.

1.116 Given the difficulty in determining the ownership structure of trusts and companies, it is not possible to accurately estimate the number of small businesses likely to be affected.

Analysis of the costs and benefits associated with each implementation option

Option 1

1.117 Amending the percentage requirements would enable some small businesses run through a company or trust to access the concessions even if they do not currently have a controlling individual. The number of stakeholders that a business could have and still access the concessions is included in the information on Option 1.

Government revenue ($ million)

Negative figures indicate a cost to revenue

Option 2

1.118 Amending the percentage requirements would enable some small businesses run through a company or trust to access the concessions even if they do not currently have a controlling individual. The number of stakeholders that a business could have and still access the concessions is included in the information in Option 1.

1.119 In addition, allowing the significant individual test to be satisfied either directly or indirectly through one or more interposed entities (rather than just through direct ownership as at present) would have the advantage of assessing the real economic interest that individuals have in a small business, rather than just their direct interest.

1.120 Currently, some small businesses are excluded from the concessions because of a tiered ownership structure. For example, a business structure that has an individual with a 100 per cent stake in a discretionary trust which has a 100 per cent stake in a unit trust or company, does not have a controlling individual. Under Option 2, the individual's 100 per cent stake in the unit trust or company, held indirectly through the discretionary trust, would be taken into account.

Government revenue ($ million)

* The nature of this measure is such that a reliable estimate cannot be provided. Where a value is followed by *, the estimate is considered indicative of the order of magnitude only.

Negative figures indicate a cost to revenue.

Option 3

1.121 Allowing the controlling individual test to be satisfied by combining the interests of close family members would have the effect of allowing more small business taxpayers to access the small business CGT concessions; however a number of complications would arise.

•

It would be necessary to determine what would constitute family interests for the purpose of the test, for example, spouses, children, only dependent children, siblings or more extended family.

•

It would also be necessary to determine which family member would be the controlling individual on the basis of the aggregated family interest. This would be especially difficult (and likely to give rise to dispute) if they have equal interests.

•

Some structures could be inappropriately excluded, for example if a non-family group jointly owned a company (or if the parents and children grouping was used, three or more siblings or more removed family members), the company would not have a controlling individual, but if they were two parents and a child, it would.

Government revenue ($ million)

* The nature of this measure is such that a reliable estimate cannot be provided. Where a value is followed by *, the estimate is considered indicative of the order of magnitude only.

Negative figures indicate a cost to revenue.

Compliance costs for all options

1.122 Small businesses that will be affected would already be required to keep records of CGT assets, acquisition date, etc, for tax purposes, and having access to the concessions is likely to have little impact on these requirements. Gaining access to the 15-year and the retirement exemptions will mean that exempt capital gains will not need to be reported in a business or individual tax return, which is expected to reduce compliance costs for small businesses.

Administrative costs for all options

1.123 The Australian Taxation Office (ATO) has advised that there is minimal administrative impact for any of the options and no need for further resources.

Consultation

1.124 This proposal arose out of the Board of Taxation's post implementation review of the small business CGT concessions. A number of submissions made to the Board of Taxation highlighted that the availability of the small business CGT concessions differs significantly depending on the structure of the business.

1.125 Several of the submissions recommended a 'family-based' controlling individual test, rather than the current treatment which looks at the interests of each individual separately. There were also suggestions that the test should be satisfied either directly or indirectly through one or more interposed entities, rather than just through direct ownership as at present.

1.126 Draft legislation was made available to tax and industry body representatives. Consultation participants provided substantial feedback on the whole draft, and in particular on how the measurement of indirect interests could be achieved.

Conclusion and recommended option

1.127 Option 2c (replacing the controlling individual test with a significant individual test with a requirement of a 20 per cent interest and allowing the requirement to be satisfied either directly or indirectly) is preferred.

1.128 The 20 per cent requirement allows additional small business taxpayers to access the concessions, while allowing indirect as well as direct interests has the additional advantage of assessing the real economic interests in the business.

1.129 The small business concessions are intended for active participants in a small business, and the significant individual test represents a readily verifiable proxy for active participation. This reflects the fact that there is typically minimal separation of significant underlying ownership from management in small businesses. Put more simply, those who own a small business tend to run the business.

1.130 The Treasury and ATO will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis.

Chapter 2 Clarification of exemptions from interest withholding tax

Outline of chapter

2.1 Schedule 2 to this Bill identifies those non-debenture debt interests that are eligible for exemption from interest withholding tax for the purposes of sections 128F and 128FA of the Income Tax Assessment Act 1936 (ITAA 1936), and introduces regulation-making powers to prescribe further types of eligible debt interests and to exclude from exemption interest payments in certain circumstances.

2.2 This Schedule seeks to reduce uncertainty for taxpayers and tax administrators associated with the operation of sections 128F and 128FA, by confirming the policy intent for provision of interest withholding tax exemptions in relation to debt interests.

2.3 The Schedule does not seek to upset the long held and accepted market views as to what constitutes a debenture. It will, however, provide a safeguard against unintended broadening of the range of financial instruments eligible for exemption.

2.4 Unless otherwise stated, all legislative references are to the ITAA 1936.

Context of amendments

2.5 Interest withholding tax was first imposed in 1968 to replace an assessment system of taxing interest payments to non-residents that was open to abuse. The view underlying the new system was that since interest withholding tax levied by Australia would generate a tax credit in the lender's home country, the burden of the tax would fall on foreign revenue collections. Unfortunately, the response of many foreign lenders was to increase interest margins on loans to Australia, shifting the burden of the tax to Australian borrowers. To avoid imposing higher capital costs on Australian business, exemptions from interest withholding tax were introduced in 1971 for certain types of offshore borrowing. These exemptions were limited. The prime objective of the exemptions was, and has remained, to ensure Australian business does not face a higher cost of capital as a consequence of the imposition of interest withholding tax. The limitations recognised that some forms of money raising have the potential to reduce the integrity of Australia's tax system and, consequently, the exemptions were targeted at arm's-length arrangements.

2.6 Subsequent amendments circumscribed eligibility for financial instruments to those expected to fulfil an arm's-length capital raising function, in circumstances where shifting of the tax burden was most likely to occur. The introduction of concepts such as 'widely held' and the 'public offer test' confirmed the original policy intent of restricting exemption to structured capital raisings for business activities while excluding related party transactions and individually negotiated loans.

2.7 Prior to 2005, section 128F provided exemption only for interest paid by a company to a non-resident on a debenture that satisfied the public offer test and certain other conditions. Legislative amendments in 2005 extended the exemption from interest on a debenture to interest on a debenture or a debt interest. The extension was made to reflect changes to Australia's debt / equity rules in 2001. Prompted by the development of innovative financing arrangements, the debt / equity changes replaced legal form tests for characterising financing arrangements as debt or equity with tests using economic substance. The 2005 amendments to section 128F echoed these developments and enabled interest on debt interests under the new debt / equity rules to be eligible for the interest withholding tax exemption, provided they also satisfied the other eligibility requirements and, in particular, the public offer test. For example, the 2005 changes enabled interest on close substitutes for debentures in capital raisings by companies, such as redeemable preference shares, to be eligible for the tax exemption.

2.8 In a similar way to section 128F, section 128FA provides for exemption from interest withholding tax for interest payments to non-residents. Prior to the 2005 amendments, section 128FA provided for interest withholding tax exemption only for interest paid on debentures issued by the trustee of an eligible unit trust. The 2005 amendments to section 128FA were also driven by the 2001 debt / equity rule changes, and extended interest withholding tax exemption to interest on debt interests that also satisfied the other eligibility requirements.

2.9 The continuing requirement that debentures and debt interests meet the public offer test limits the range of debentures and debt interests qualifying for interest withholding tax exemption. However, interpretative pressure on the relevant law has the potential to substantially widen the range of debentures and debt interests that could qualify for exemption from interest withholding tax, beyond the original policy intent. This represents a threat to the integrity of the tax system.

2.10 'Debenture' is currently defined for the purposes of sections 128F and 128FA to include debenture stock, bonds, notes and any other securities of the company (whether or not constituting a charge over the assets of the company), promissory notes and bills of exchange. The scope of the term debenture is generally considered to be a matter of some uncertainty, with the terms debenture and security having broad common law meanings. However, relevant case law suggests that a debenture is a transferable document that either creates or acknowledges a debt (rather than merely evidencing it). While promissory notes and bills of exchange are not customarily held to be debentures under common law, they were inserted into the definition of debenture for the purposes of these provisions. Savings accounts, transaction or current accounts, term deposits and non-transferable certificates of deposit would not generally be regarded as debentures or securities. However, on a strict legal form assessment, it is possible that certain financial instruments that have not traditionally been regarded as debentures could be interpreted as such.

2.11 To safeguard against this outcome, and provide clearer guidance to the market in relation to the eligibility of debentures for interest withholding tax exemption, a regulation-making power has been included. This will enable the exclusion from eligibility for exemption of interest on certain financial instruments, where a particular outcome is not supported by the overall policy intent for these provisions. However, it is not intended that regulations be made to upset long held and accepted market views as to what constitutes a debenture. Rather, this power could be expected to be utilised in response to the future emergence of a markedly broader legal interpretation of 'debenture' or where a financial instrument is declared to be a debenture but has characteristics or features more in keeping with financial instruments for which exemption has not traditionally been claimed and would not be appropriate. In both circumstances, consideration could be expected to be given to those financial instruments, beyond matters of legal form (including transferability or negotiability), that do not seem to fulfil an arm's-length offshore capital raising function nor seem reasonably likely to be associated with a shifting of the incidence of interest withholding tax. Such a circumstance could be expected to include efforts to broaden debenture to incorporate a range of non-negotiable, routinely available, wholesale and retail financial instruments or products.

2.12 'Debt interest' is defined by reference to Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997). It is a broad term that includes both financial instruments and financing arrangements, and embeds the concept of a non-contingent obligation to pay an amount to the holder of the debt interest, at least equal to its issue price, in the future. For the holder, this reflects receipt of a financial benefit, which need not amount to interest. It has resulted in certain financial instruments that would previously have been regarded as equity now being categorised as debt. Provided these debt interests give rise to interest, payment of that interest may attract interest withholding tax. It includes debentures and the range of standard retail and wholesale products offered by financial institutions (the Australian Taxation Office has publicly accepted as debt interests transferable certificates of deposit and syndicated loans) as well as hybrid debt / equity instruments such as non-equity shares.

2.13 The amendments clarify the range of interest payments to non-residents on non-debenture debt interests that qualify for interest withholding tax exemption, consistent with the policy intent at the time the original amendments were introduced in 2005. At that time, the Government had intended providing eligibility for hybrid financial instruments regarded as debt under Division 974 of the ITAA 1997. The most obvious example is a non-equity share, such as a redeemable preference share. The inclusion of a regulation-making power in the amendments to prescribe further eligible debt interests will enable other (possibly yet to be developed) hybrid instruments to be made eligible where they perform a similar capital raising role in similar circumstances to currently eligible debentures and debt interests. Regulations could also be made to provide transitional arrangements, as appropriate, in relation to debt interests issued since the 2005 amendments.

2.14 The specification of non-equity shares in the context of section 128FA, which deals with unit trusts, is not intended to reflect a possibility that such instruments could be issued directly by a trustee but more limited circumstances that could arise in the context of an offshore subsidiary company (subsection 128FA(5)). Similarly, the insertion of non-equity shares in those provisions making reference to a qualifying security should not be interpreted as implying a non-equity share would necessarily constitute a security under income tax law.

Summary of new law

2.15 Interest payments on qualifying debentures issued by companies and unit trusts will qualify for interest withholding tax exemption, unless the interest paid on that debenture is prescribed by regulation as not eligible for exemption.

2.16 The amendments will specify that only non-debenture debt interests that are non-equity shares will be eligible for interest withholding tax exemption, unless a debt interest qualifies for exemption by regulation.

Comparison of key features of new law and current law

Detailed explanation of new law

What is interest withholding tax?

2.17 The taxation of interest paid or credited from Australia to non-residents, and residents operating through offshore permanent establishments, is dealt with by the interest withholding tax provisions contained in Division 11A of Part III. These provisions provide, in conjunction with the Income Tax (Dividends, Interest and Royalties) Withholding Tax Act 1974, that the recipient of the interest is subject to withholding tax on the gross amount paid or credited. A rate of 10 per cent of the gross amount of the interest is imposed. The obligation for collecting the interest withholding tax is placed on the person making the payment. The provisions define 'interest' and stipulate when an amount of interest is subject to withholding tax.

Interest withholding tax exemptions

2.18 Under certain circumstances, Division 11A provides exemptions from interest withholding tax. In the context of these amendments, the following exemptions are relevant:

•

Section 128F provides that where an Australian resident company, or a non-resident company carrying on business at or through a permanent establishment in Australia, issues a debenture, or a non-debenture debt interest that is a non-equity share, or a non-debenture debt interest that is prescribed by regulation, and the issue satisfies the requirement of the public offer test contained in subsection 128F(3) or (4), then an exemption from interest withholding tax will apply. In the absence of the exemption, interest withholding tax would be payable on the interest paid to non-resident holders of the debenture, or non-debenture debt interest that is a non-equity share, or non-debenture debt interest that is prescribed by regulation.

•

In a similar way to section 128F, section 128FA provides for exemption from interest withholding tax for the interest paid to a non-resident by the trustee of certain unit trusts on a debenture, or a non-debenture debt interest that is a non-equity share, or a non-debenture debt interest that is prescribed by regulation and the issue of the security satisfies the public offer test.

What is the public offer test?

2.19 A public offer test must be satisfied for interest to be exempt from interest withholding tax under section 128F or section 128FA. The issue of a debenture or a non-debenture debt interest that is a non-equity share, or a non-debenture debt interest that is prescribed by regulation must satisfy one of the five tests listed below. The debenture or non-debenture debt interest that is a non-equity share or non-debenture debt interest that is prescribed by regulation must be offered:

•

to at least 10 persons who were each carrying on the business of providing finance, or investing or dealing in securities, as participants in financial markets;

•

to at least 100 investors who have acquired debentures in the past or could reasonably be likely to be interested in acquiring debentures;

•

as a result of being accepted for listing on a stock exchange, where the company or trustee of the unit trust had previously entered into an agreement with a dealer, manager or underwriter, requiring the company or trustee to seek such listing;

•

as a result of negotiations being initiated publicly in electronic form, or in another form, that was used by financial markets for dealing in debentures or debt interests; or

•

to a dealer, manager or underwriter for the purpose of placement of the debenture or debt interest if the dealer, manager or underwriter satisfies one of the previous tests.

2.20 An issue of a debenture or a non-debenture debt interest that is either a non-equity share or prescribed by regulation will always fail the public offer test, with consequential loss of eligibility for the exemption, if, at the time of issue, the company or trustee was aware or suspected that the debenture or debt interest would be acquired by associates of the issuing company or the unit trust, other than associates acting in the capacity of a dealer, manager or underwriter. The exemption is also denied if the issuing company or trustee is aware or suspects that the interest on the debentures or non-debenture debt interests is being paid to an associate of the company or trust.

Clarification of section 128F: Interest paid to a non-resident by a resident company or a non-resident company that maintains a permanent establishment in Australia

2.21 Current provisions in the law provide for interest withholding tax exemption for interest on a debenture or a debt interest where the debenture or debt interest meets the public offer test and some other conditions. These amendments have the effect, while retaining the public offer test and other conditions to be met, of specifying more closely the debenture or debt interests eligible for interest withholding tax exemption.

2.22 Closer specification of eligible debt interests is achieved by adding two additional conditions for interest paid by a resident Australian company:

•

Interest on a debt interest is eligible if the interest is on a non-debenture debt interest that is also a non-equity share. This restricts the range of eligible debt interests [ Schedule 2, item 1, subparagraph 128F(1)(f)(i )].

•

Interest on a debt interest is eligible if the interest is on a non-debenture debt interest that has been prescribed by regulation. This allows for the extension of eligible debt interests [ Schedule 2, item 1, subparagraph 128F(1A)(f)(ii )].

2.23 Identical conditions to those in paragraph 2.22 are to apply to interest paid to non-residents by non-resident companies that maintain a permanent establishment in Australia. [ Schedule 2, item 2, paragraph 128F(1A)(e )]

2.24 Identical conditions to that in paragraph 2.22 are inserted to ensure that where the purchase price of an eligible debenture or debt interest is composed in part of interest, that embedded interest is only eligible for interest withholding tax exemption if it is on an eligible debenture or non-debenture debt interest that is a non-equity share or is prescribed by regulation. [ Schedule 2, item 3, paragraph 128F(1B)(c )]

2.25 Further specification of eligible interest for both debentures and debt interests is achieved by inserting an additional regulation-making power that provides for prescription of any interest as not eligible for exemption from interest withholding tax. Such interest may be interest on a debenture or interest on a debt interest. [ Schedule 2, item 4, subsection 128F(1C )]

Clarification of section 128FA: Interest paid by the trustee of an eligible unit trust on a debt interest to a non-resident

2.26 Current provisions in the law provide for interest withholding tax exemption for interest on a debenture or a debt interest where both the debenture and debt interest meet the public offer test and some other conditions. The amendments have the effect, while retaining the public offer test and other conditions to be met, of specifying more closely the debenture or debt interests eligible for interest withholding tax exemption.

2.27 Closer specification of eligible interest on debt interests paid by the trustee of certain trusts is achieved by adding two additional conditions:

•

Interest on a debt interest is eligible if the interest is on a non-debenture debt interest that is also a non-equity share. This restricts the range of eligible debt interests [ Schedule 2, item 5, subparagraph 128FA(1)(b)(i )].

•

Interest on a debt interest is eligible if the interest is on a non-debenture debt interest that has been prescribed by regulation. This allows for the extension of eligible debt interests [ Schedule 2, item 5, subparagraph 128FA(1)(b)(ii )].

2.28 An identical condition to that in paragraph 2.27 is inserted to ensure that where the purchase price of an eligible debenture or debt interest is composed in part of interest, that embedded interest is only eligible for interest withholding tax exemption if it is on an eligible debenture or non-debenture debt interest that is a non-equity share or is prescribed by regulation. [ Schedule 2, item 6, paragraph 128FA(2)(c )]

2.29 Further specification of eligible interest for both debentures and debt interests is achieved by inserting an additional regulation-making power that provides for prescription of any interest as not eligible for exemption. Such interest may be interest on a debenture or interest on a debt interest. [ Schedule 2, item 7, subsection 128FA(2A )]

Application and transitional provisions

2.30 The amendments limiting eligible debt interests to non-debenture debt interests that are non-equity shares will apply to debt interests issued on or after the day on which this Bill is introduced in the House of Representatives [ Schedule 2, item 8 ]. The amendments establishing regulation-making powers will have effect from the date of Royal Assent.

Chapter 3 Streamline gift fund and integrity arrangements for deductible gift recipients

Outline of chapter

3.1 Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to remove the requirement for certain deductible gift recipients (DGRs) to maintain a gift fund. It also amends the Taxation Administration Act 1953 (TAA 1953) to allow the Commissioner of Taxation (Commissioner) to review whether an entity listed in the law continues to be eligible to receive deductible gifts, in the same way that the Commissioner can review the eligibility of those entities that require the Commissioner's endorsement. All DGRs are now required by law to maintain adequate accounting records.

Context of amendments

3.2 As part of the 2006-07 Budget, the Minister for Revenue and Assistant Treasurer announced on 9 May 2006, measures to enhance philanthropy and streamline DGR arrangements.

3.3 The amendments reduce compliance costs associated with maintaining DGR gift funds. The amendments are also intended to streamline and strengthen the DGR integrity arrangements and hence increase public confidence in DGRs.

3.4 As part of the DGR integrity arrangements, endorsed DGRs are required to maintain gifts and contributions in a separate fund. To reduce compliance costs the amendments, in some cases, remove the requirement for DGRs to maintain gift funds; and for DGRs to maintain one gift fund rather than multiple gift funds.

3.5 Currently the Commissioner is empowered to review endorsed DGRs to assess if they continue to be entitled to endorsement, including whether their activities remain consistent with the principal purpose for which DGR status was granted. The amendments standardise integrity arrangements across all DGRs by allowing the Commissioner to review listed DGRs in the same manner as endorsed DGRs.

Summary of new law

3.6 These amendments standardise the integrity arrangements for all DGRs, so that listed DGRs can now be reviewed by the Commissioner in line with the Commissioner's current powers to review endorsed DGRs, to determine if they continue to meet the conditions of their DGR status. To this end, the amendments empower the Commissioner to request information that is relevant to the listed entity's DGR status.

3.7 These amendments also remove the gift fund requirement for an entity that is a deductible fund, authority or institution. For an entity that operates a deductible fund, authority or institution, the requirement to maintain a separate gift fund remains. However, where an entity operates more than one deductible fund, authority or institution, it can consolidate its multiple gift funds into a single gift fund.

3.8 These amendments also make explicit the current requirements for all DGRs to maintain adequate accounting records so that donations of money or property can be identified separately from other receipts and their uses can be tracked. Tax deductible donations continue to be used solely for the principal purpose for which the organisation was granted DGR status.

Comparison of key features of new law and current law

Detailed explanation of new law

Enhancements to DGR integrity arrangements

3.9 Currently the integrity arrangements differ between DGRs that have been endorsed by the Commissioner and those listed in the ITAA 1997. To align the integrity arrangements for all DGRs, these amendments allow the Commissioner to review listed DGRs in the same manner as endorsed DGRs and to request information from a listed DGR that is relevant to its DGR status. [ Schedule 3, item 8, subsection 353-20(1 ) of the TAA 1953 ]

3.10 The Commissioner is currently empowered to request information that is relevant to an endorsed DGR's status. These powers are outlined in Division 426 of the TAA 1953 which deals with the Commissioner's role in endorsing DGRs.

3.11 The DGR must comply with the Commissioner's request for information. Failure to comply is an offence under section 8C of the TAA 1953. The inclusion of an offence provision for listed DGRs is consistent with the penalty that is applicable for all failures to comply with requests for information by the Commissioner.

3.12 The revocation powers conferred on the Commissioner under Division 426 do not extend to listed DGRs. The authority to remove a listed DGR remains with the Government and Parliament.

3.13 The amendments require the Commissioner to provide information to the relevant Minister where the Commissioner finds that a listed DGR no longer meets the conditions for which it was granted DGR status. The Commissioner must give written notice to the relevant Minister within 28 days of being satisfied that certain conditions relevant to the DGR status of the listed entity have been met. [ Schedule 3, item 8, subsection 353-20(4 ) of the TAA 1953 ]

3.14 The Commissioner is to provide to the relevant Minister all information that is relevant to the DGR status of a listed entity. In considering what information is required for this purpose the Commissioner will have regard to guidelines and conditions that may attach to a listing, including those that cover prescribed private funds, that are issued to assist the assessment of DGR status. [ Schedule 3, item 8, paragraph 353-20(4)(c ) of the TAA 1953 ]

3.15 The amendments require that the Commissioner, in giving written notice to the relevant Minister regarding the status of a listed DGR, may only include such information that is relevant to the DGR's status. The amendments also limit the use of information to assess whether the organisation's continued DGR status is warranted. In this way, safeguards exist within the legislation to constrain the use of such information for the administration of DGRs. [ Schedule 3, item 8, subsection 353-20(3 ) of the TAA 1953 ]

Removal of the gift fund requirement

3.16 Currently all DGRs are required to maintain a separate gift fund to hold deductible gifts or contributions. To reduce administrative costs associated with this requirement, the amendments:

•

remove the requirement to maintain a gift fund for an entity that is endorsed as a deductible fund, authority or institution (Type A DGR); and

•

allow an entity that operates a deductible fund, authority or institution (Type B DGR) to consolidate its multiple gift funds into a single gift fund.

3.17 The amendments modifying the gift fund requirements do not override existing requirements where an entity must maintain a public fund to gain endorsement as a DGR and that a gift or contribution may only be used for the principal purpose for which it was granted DGR status.

Type A DGR entities

3.18 The amendments remove the requirement for Type A DGRs to maintain a gift fund. For example, the Bloedworth Service is a public benevolent institution that operates a hostel and a detox centre through its two Divisions. All the money or property handled by Bloedworth Service is used to further DGR purposes and therefore it is not required to maintain a gift fund, however, it retains the option to retain a gift fund if it chooses. [ Schedule 3, items 1 and 2, subsections 30-125(1 ) and ( 2 ) of the ITAA 1997 ]

Type B DGR entities

3.19 The amendments continue to require a gift fund to be maintained for Type B DGRs. That is, all gifts and contributions must be maintained in a gift fund that is maintained separately to all non-DGR property of the entity. However where a Type B DGR operates more than one deductible fund, authority or institution, it can choose to consolidate its multiple DGR gift funds into a single gift fund. [ Schedule 3, item 7, subsection 30-130(3 ) of the ITAA 1997 ]

3.20 For example, the Knoxville parish of the Uniting Church is endorsed to operate a school building fund in each of the two schools within its parish. The parish also operates a refuge centre that is endorsed as a public benevolent institution. The Knoxville parish can consolidate the gift funds into a single gift fund. It will not, however, be able to consolidate money or property contained in its parish account with the single gift fund.

3.21 The existing requirement that gifts and contributions are only to be used for the principal purpose of the fund, authority or institution to which that gift or contribution relates continues to apply. While these amendments allow donations across multiple DGR gift funds to be consolidated into a single gift fund, donations provided to one DGR may not be transferred to support another.

3.22 A DGR is still required to transfer all remaining gifts and contributions to another DGR on winding up. The amendments define the assets that are required to be transferred to another DGR on wind up to include all remaining gifts, contributions and any income earned in respect of those gifts and contributions. [ Schedule 3, item 4, subsection 30-125(6 ) of the ITAA 1997 ]

Record-keeping requirements

3.23 All DGRs are currently expected to maintain adequate accounting and other records to show that DGR funds are only used in a manner that is consistent with the principal purpose of the fund, authority or institution that has been granted DGR status.

3.24 The separate identification of gifts and contributions from other monies or property forms an important integrity requirement of the DGR arrangements. To enhance those arrangements, the amendments require all DGRs to keep records that explain all transactions that are relevant to the DGR status of the fund, authority or institution. [ Schedule 3, item 10, subsection 382-15(1 ) of the TAA 1953 ]

3.25 The amendments detail the record-keeping requirements that must be maintained by all DGRs (including those endorsed or listed DGRs including prescribed private funds) to verify that tax deductible gifts or contributions are used only for the principal purpose of the fund, authority or institution. [ Schedule 3, item 10, subsection 382-15(2 ) of the TAA 1953 ]

3.26 Where an entity has consolidated a number of funds, the records must be able to identify donations made in respect of each separate fund, authority or institution and to show how the gifts to each fund, authority or institution have been used to further the principal purpose of that fund, authority or institution.

Application and transitional provisions

3.27 This measure commences on Royal Assent.

Chapter 4 Deductible gift recipients

Outline of chapter

4.1 Schedule 4 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to extend the period for which deductions are allowed for gifts to certain funds that have time limited deductible gift recipient (DGR) status.

Context of amendments

4.2 The income tax law allows taxpayers to claim income tax deductions for gifts of $2 or more to DGRs. To be a DGR, an organisation must fall within a category of organisations set out in Division 30 of the ITAA 1997, or be listed by name under that Division.

4.3 DGR status assists relevant funds and organisations to attract public support for their activities.

Summary of new law

4.4 These amendments extend the period for which deductions are allowed for gifts to certain funds that have time limited DGR status. The extension will support the completion of work of the relevant organisation.

Comparison of key features of new law and current law

4.5 Schedule 4 extends the period for which deductions are allowed for gifts to the organisation listed in Table 4.1. [ Schedule 4, items 1 to 4 ]

4.6 The Dunn and Lewis Youth Development Foundation Limited was granted a 12-month extension to support the construction of a complex that will serve as a memorial, a recreational outlet and a vocational training centre to link young people in Ulladulla with traineeships and other employment opportunities. [ Schedule 4, item 2 ]

4.7 The Rotary Leadership Victoria Australian Embassy for Timor-Leste Fund Limited was granted an extension to assist the Rotary Club of Melbourne and Leadership Victoria, to raise funds to complete the construction of an embassy for East Timor in Canberra on land provided by the Government. [ Schedule 4, item 1 ]

4.8 St George's Cathedral Restoration Fund was granted an extension to assist St George's Anglican Cathedral in Perth to raise funds to complete the urgent and critical components of the reconstruction and conservation work on the Cathedral and Burt Memorial Hall. [ Schedule 4, item 3 ]

4.9 St Michael's Church Restoration Fund was granted a 12-month extension to assist St Michael's Uniting Church in Melbourne to support urgent critical repair work to the Church building. [ Schedule 4, item 4 ]

Chapter 5 Effective life of tractors and harvesters

Outline of chapter

5.1 Schedule 5 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to insert statutory 'caps' (referred to as 'capped lives') of 6? years for tractors and harvesters used in the primary production sector.

Context of amendments

5.2 Under the uniform capital allowance provisions of the income tax law, taxpayers can deduct amounts for the decline in value of their depreciating assets. That decline in value is generally worked out using the 'effective life' of the asset. Broadly, the effective life of the asset is the period over which any taxpayer is able to use the asset for a taxable purpose or for the purpose of producing exempt or non-assessable non-exempt income.

5.3 A taxpayer can self assess their own effective life or alternatively use the 'safe harbour' effective life, which is one determined by the Commissioner of Taxation (Commissioner), if there is one in force at the time. Currently, for tractors and harvesters, the Commissioner has in place a safe harbour effective life determination of 6? years. This has remained unchanged since 1956.

5.4 Since 2000, the Commissioner has been reviewing the effective life of depreciating assets, to ensure that they reflect the period over which assets can be used for the purpose of producing assessable income or for the purpose of producing exempt income or non-assessable non-exempt income. The review process was one of the outcomes from the 1999 Review of Business Taxation - A Tax System Redesigned (the Ralph Report).

5.5 The Commissioner has been reviewing the effective life of assets used in the primary production sector. As a consequence of the review process the Commissioner may increase the current safe harbour effective life of 6? years for tractors and harvesters.

5.6 Under the uniform capital allowances system, capped, or shorter, effective lives apply to certain depreciating assets, and in some cases, to those used in specified industries, under section 40-102 of the ITAA 1997. The capped lives override the Commissioner-determined effective lives where the capped lives are shorter than the effective lives as determined by the Commissioner.

5.7 By prescribing a statutory cap for tractors and harvesters used in the primary production sector, taxpayers who choose to use the effective life determined by the Commissioner will be limited to an effective life of 6? years or the effective life determined by the Commissioner, whichever is the shorter.

Summary of new law

5.8 This Schedule adds a new statutory cap of 6? years to the uniform capital allowances regime for tractors and harvesters used in the primary production sector.

Comparison of key features of new law and current law

Detailed explanation of new law

5.9 Under the uniform capital allowance provisions of the income tax law, taxpayers can deduct amounts for the decline in value of their depreciating assets. That decline in value is generally worked out using the effective life of the asset.

5.10 A taxpayer may choose either to self assess the effective life of an asset or use an effective life, determined by the Commissioner for an asset, where there is one in force at the relevant time.

5.11 If a taxpayer chooses to use the effective life determined by the Commissioner, the taxpayer can access a capped life if one applies to that asset under section 40-102 of the ITAA 1997. If a capped life applies, and it is shorter than the effective life determined by the Commissioner, the taxpayer must use the capped life.

5.12 A capped effective life of 6? years applies to tractors and harvesters used in the primary production sector. [ Schedule 5, item 1, subsection 40-102(5 ), items 7 and 8 in the table ]

5.13 The term 'primary production sector' covers primary production industries and those providing services to primary production. Therefore it includes contractor suppliers of tractor and harvesting services as well as taxpayers carrying on a primary production business. [ Schedule 5, item 1, subsection 40-102(5 )]

Application and transitional provisions

5.14 This measure applies to a depreciating asset if the start time for the asset (broadly, when the asset is first installed or used) occurs on or after 1 July 2007. [ Schedule 5, item 2 ]

Chapter 6 Farm management deposits

Outline of chapter

6.1 Schedule 6 to this Bill amends the Income Tax Assessment Act 1936 (ITAA 1936) to increase the non-primary production income threshold and to increase the total deposit limit for farm management deposits.

Context of amendments

6.2 Schedule 2G to the ITAA 1936 contains the provisions for farm management deposits. A farm management deposit is a tax-linked, financial risk management tool for primary producers that is designed to allow primary producers to set aside income from profitable years for subsequent 'draw-down' in low-income years. This reduces the risk to primary producers of income variability owing to factors such as drought.

6.3 An individual primary producer with taxable non-primary production income of $50,000 or less for the year of income is able to make a farm management deposit (paragraph 393-10(1)(b)). The total deposit limit is $300,000 (subsection 393-35(6)).

6.4 These thresholds have not been amended since the introduction of farm management deposits in 1999 and increasing these thresholds will assist primary producers to cope with the ongoing drought.

Summary of new law

6.5 Schedule 6 increases the non-primary production income threshold from $50,000 to $65,000 per income year and the total amount that a primary producer can hold in a farm management deposit from $300,000 to $400,000.

Comparison of key features of new law and current law

Detailed explanation of new law

6.6 This Schedule will increase the non-primary production income threshold from $50,000 to $65,000 per income year. This will allow more primary producers to hold farm management deposits as well as allow current holders to earn a larger amount of non-primary production income each income year without becoming ineligible for the Scheme. [ Schedule 6, item 1, paragraph 393-10(1)(b )]

6.7 This measure will also increase the total amount that a primary producer can hold in a farm management deposit from $300,000 to $400,000 [ Schedule 6, item 3, subsection 393-35(6 )]. A consequential amendment is made to the heading of subsection 393-35(6) to reflect the threshold change [ Schedule 6, item 2, heading in subsection 393-35(6 )].

Application and transitional provisions

6.8 The amendments made by this Schedule apply to assessments for the year of income in which this Bill receives Royal Assent and later years of income. [ Schedule 6, item 4 ]

Chapter 7 Capital protected borrowings

Outline of chapter

7.1 Schedule 7 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to ensure that where part of the expense of a capital protected borrowing (CPB) is attributed to the cost of the capital protection feature it is:

•

not interest; and

•

not deductible where this cost is capital in nature.

Context of amendments

7.2 A typical CPB is a limited recourse loan facility which is used to fund the purchase of shares, units or stapled securities. The nature of the facility is such that the borrower has the right to satisfy the outstanding loan by transferring the shares, units in a unit trust or stapled securities back to the lender. Consequently, the borrower is protected if there is a fall in the price of the shares, units in a unit trust or stapled securities acquired under the loan facility. Such an arrangement can be viewed as, or disaggregated into, a full recourse loan and an embedded put option.

7.3 The cost of the capital protection component is included in, and takes the form of, 'interest' payable on the loan. As a result, the total 'periodic' expense (labelled 'interest') paid by the holder of a CPB may be considerably higher than the interest payable on a borrowing facility without capital protection.

7.4 Another common type of CPB involves a full recourse loan to fund the purchase of shares, units or stapled securities and an explicit put option to hedge the value of the securities.

Example 7.1: CPB with an embedded put option

A borrower borrows $100,000 from a bank for a period of one year and uses this amount to acquire $100,000 of shares listed on the Australian Stock Exchange (ASX).

At the end of the CPB, the borrower can either repay the loan or put the shares back to the bank in satisfaction of the loan. If at that time the value of the shares is greater than $100,000, the borrower will repay the loan. If the value of the shares is less than $100,000 the borrower will put the shares back to the bank in exchange for full satisfaction of the loan (ie, $100,000).

Firth's case

7.5 The proposed measures dealing with the taxation of CPBs are to amend the ITAA 1997 to overcome the decision in the Commissioner of Taxation vs Firth
120 FCR 450 (Firth's case). In that case the Full Federal Court ruled that the component of 'interest' applicable to the cost of the capital protection feature is deductible when paid. On 5 November 2002, the High Court refused special leave for the Commissioner of Taxation (Commissioner) to appeal this decision.

7.6 The decision in Firth's case allows a borrower a more favourable tax treatment for a CPB that does not have a separately identifiable capital protection feature relative to a CPB that has a separately identifiable capital protection feature that is, it allows borrowers to obtain an income tax deduction for what may be in substance a capital cost (being the cost of the put option implicit in limited recourse loans). This different tax treatment based on form, not substance, may distort investment decisions.

Tax treatment of components of a Firth-type CPB

7.7 The CPB in Firth's case consisted of:

•

a limited recourse loan made to acquire a beneficial interest in the underlying securities, which could be satisfied by putting the securities to the lender; and

•

the borrower's beneficial interest in the underlying securities.

7.8 Interest incurred on the limited recourse loan used to purchase securities may be deductible in accordance with section 8-1 of the ITAA 1997.

7.9 Any income from the underlying securities acquired by the funding under the loan is usually subject to tax, as is any capital gain on disposal of the underlying securities. Any capital loss on disposal will be subject to the quarantine provision of the capital gains tax (CGT) provisions meaning that it could only be offset against a capital gain.

Government announcements

7.10 On 16 April 2003 the Treasurer announced in Press Release No. 019 (Taxation of Capital Protected Products) that the ITAA 1997 would be amended to ensure that part of the expense on a CPB will be attributed to the cost of the capital protection feature, will not be interest and is not deductible where this cost is capital in nature. The announcement stated that the amendment is to apply to arrangements, including extensions of existing arrangements, entered into on or after 9.30 am by legal time in the Australian Capital Territory on 16 April 2003.

7.11 On 30 May 2003 the then Minister for Revenue and Assistant Treasurer announced in Press Release C046/03 (Taxation of Capital Protected Products) an interim approach to be used to apportion the expense on CPBs between the interest on the loan component and the cost of the capital protection component. This interim approach was to apply until a longer term methodology was developed following consultation with industry. The interim approach is to apply from 16 April 2003 until 1 July 2007 at which time the longer term methodology commences application.

Summary of new law

7.12 This measure will treat capital protection under a CPB that is not provided under an explicit put option as though it is a put option that is acquired by the borrower under the CPB. This measure will also treat the amount incurred in respect of such capital protection as though it is a put option premium paid by the borrower under the CPB to the provider of the capital protection under the CPB. The measure will also apply to CPBs with explicit put options.

7.13 Broadly, under the interim methodology this is achieved through two methodologies. Where an instalment warrant is acquired on the primary market, the price of the separately priced explicit put option is the cost of capital protection where it reasonably reflects market value. For other CPBs the cost of capital protection is the higher of the amount calculated under the indicator method (total amounts in excess of a benchmark interest rate) and the percentage method (total amounts incurred times a set percentage).

7.14 Under the ongoing methodology, the amount incurred that is reasonably attributable to the cost of capital protection is the amount by which the total amount incurred by the borrower under the borrowing, exceeds the total interest that would have been incurred on the borrowing at the Reserve Bank of Australia (Reserve Bank) Indicator Rate for Personal Unsecured Loans - Variable Rate.

Comparison of key features of new law and current law

Detailed explanation of new law

What is a capital protected borrowing?

7.15 A CPB is an arrangement under which there is a borrowing or a provision of credit where the borrower is, wholly or partly, protected against a fall in the market value of a thing to the extent that the borrower uses the amount borrowed or credit provided to acquire the protected thing. [ Schedule 7, item 1, paragraph 247-10(1)(a )]

7.16 A CPB is also an arrangement under which there is a borrowing or a provision of credit where the borrower is, wholly or partly protected against a fall in the market value of a thing, to the extent that the borrower uses the protected thing as security for the borrowing or provision of credit [ Schedule 7, item 1, paragraph 247-10(1)(b )]. This provision is to ensure that the legislation will apply to those arrangements where the 'something' acquired (eg, beneficial interest in shares) is different to the 'thing' of which the borrower is protected against a fall in the market value (eg, shares provided as security).

Example 7.2: Shareholder applicant in an instalment warrant

A shareholder applicant in an instalment warrant receives a loan which can be used to acquire further warrants or used for another purpose. If the 'something' acquired is not a warrant then the 'something' is different to the 'thing' of which they are protected against the fall in the market value.

7.17 This measure will apply to a particular type of CPB. That is, a CPB under which the borrowing (or credit) is used to acquire a beneficial interest, directly or indirectly, in a share, unit in a unit trust or stapled security [ Schedule 7, item 1, subsection 247-15(1 )]. CPBs to which this measure applies are essentially geared investments in securities (shares, units and stapled securities). They include CPBs listed on the ASX (called instalment warrants), and CPBs not listed on the ASX.

7.18 The beneficial interest in the shares, units in a unit trust or stapled security may be held indirectly which ensures that the amendments apply to interests in the underlying investments held in trusts. [ Schedule 7, item 1, paragraph 247-15(1)(b )]

What is capital protection?

7.19 Capital protection is defined as where the borrower under a 'capital protected borrowing' is wholly or partly protected against a fall in the market value of a thing. [ Schedule 7, item 1, subsections 247-10(1 ) and ( 2 )]

7.20 Capital protection may be provided in different forms including a separately identifiable put option, an embedded put option (eg, a put option that is not separately identifiable from a limited recourse loan) or a synthetic put option such as a dynamically replicated put option.

7.21 The capital protection that is provided by a CPB will ensure that a borrower does not suffer a loss (or will limit the amount of a loss) where the market value of the whole or part of the underlying asset (ie, the beneficial interest in shares, units in a unit trust or stapled securities) and is less than the amount the borrower is or will be liable to pay under the loan made under the CPB. More specifically:

•

the borrower will have a right to require the lender or a another entity under the arrangement to accept the whole or part of the beneficial interest; or

•

the lender or another entity under the arrangement will acquire (as the result of the exercise of a put option by the borrower) or have the obligation to acquire the whole or part of the beneficial interest,

in satisfaction of the lender's right to the whole or part of one or more amounts that the borrower is, or will be, liable to pay under the CPB.

The CPB measure only applies to borrowers

7.22 These amendments only apply to borrowers under CPBs. Any gains and losses from CPBs for the lenders in the arrangement would normally be on revenue account irrespective of the form of the CPB. [ Schedule 7, item 1, subsection 247-15(2 )]

What is an arrangement?

7.23 The term arrangement is defined in subsection 995-1(1) of the ITAA 1997 as meaning 'any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings'. The term 'arrangement' is sufficiently broad to cover the situation where two or more contracts form part of or all of one arrangement. Whether there is a single arrangement under which a CPB exists will be a matter of fact and circumstance.

Example 7.3: Single arrangement

If Bank A provides finance so that John may invest in shares on the basis that Bank B will provide the capital protection there will be a single arrangement.

Example 7.4: Separate arrangements

If John borrows money to invest in shares from Bank A and then acquires capital protection from Bank B, there will be two arrangements unless there is an agreement or understanding between Bank A and Bank B that Bank A will not provide finance unless Bank B provides capital protection.

Example 7.5: CPB to purchase a share portfolio where capital protection is provided over individual shares

Bank A offers a protected equity loan on a limited recourse basis to purchase a portfolio of shares. The terms of the loan include separate protection over the shares of each company in the portfolio so that, at maturity, a borrower can take the gains of the shares that have increased in value and surrender the shares that have fallen in value.

In the event of the borrower defaulting during the course of the loan, gains on the better performing shares would be directed to repay other costs of unwinding the facility, including the costs associated with under-performing shares.

John obtains a five-year fixed interest rate protected equity loan to purchase six shares in six different companies that constitute Bank A's recommended 'Stable Growth' portfolio. John is to pay interest on the loan at a fixed rate of 13.2 per cent per annum over five years.

Although the loan is in respect of shares in six separate companies and the capital protection is in respect of individual shares in the portfolio, the loan and share purchase is considered to be one arrangement for the purposes of Division 247.

Assuming the benchmark interest rate for the term of the loan is 12.75 per cent per annum, the cost of the capital protected borrowing facility must be apportioned as follows for tax purposes:

•

deductible interest expense - 12.75 per cent per annum; and

•

attributable to capital protection - 0.45 per cent per annum.

Application of Division 247

Beneficial interest in a share, a unit in a unit trust or a stapled security

7.24 Division 247 applies only to CPBs where the underlying beneficial interest is in shares, units and stapled securities rather than being broadly based to include other types of non-recourse project financing (eg, financing of infrastructure projects). [ Schedule 7, item 1, subsections 247-15(1 ) and ( 5 )]

7.25 The limited scope of the proposed changes reflect the difference in risks associated with a CPB over shares, units and stapled securities compared with other arrangements where a borrower's capital is protected. For example, lenders under CPBs over shares, units and stapled securities are able to offer the capital protection comparatively easily because the liquid nature of the shares, units and stapled securities allow lenders to efficiently hedge their risks associated with the arrangement. This may not be the case for a lender under a project financing arrangement. Also, the kinds of lender risks inherent in non-recourse project financing such as completion risk are not present in the case of these CPBs.

7.26 Further, non-recourse project financing relies on the project's cash flows to service the loan, while this is not the case for the CPBs to be covered by these amendments. These considerations distinguish these CPBs from the broader issue relating to non-recourse loans commonly used in project financing.

7.27 In many cases a project financing may be structured using a special purpose entity. An entity will acquire finance on a non-recourse basis to finance the purchase of shares in an unlisted special purpose company which undertakes the project. To ensure the exclusion of project finance arrangements from the amendments subsection 247-15(5) provides that Division 247 will not apply to a CPB under which:

•

the money borrowed or credit provided is used to acquire an unlisted share, unit in a unit trust or stapled security; and

•

that unlisted share, unit or stapled security is not in a widely held entity; or

•

an entity holds directly or indirectly a beneficial interest in that non-widely held unlisted share, unit or stapled security.

[ Schedule 7, item 1, subsection 247-15(5 )]

7.28 In accordance with subsection 995-1(1) of the ITAA 1997 the term 'widely held company' means:

•

a company, 'shares' in which (except shares that carry a right to a fixed rate of 'dividend') are listed for quotation in the official list of an 'approved stock exchange'; or

•

a company with more than 50 members, other than a company where at least one of the following conditions is met during an income year:

•

no more than 20 persons held, or had the right to acquire or become the holders of, shares representing at least 75 per cent of the value of the shares in the company (other than shares that only carry a right to a fixed rate of dividend);

•

at least 75 per cent of the voting power in the company was capable of being exercised by no more than 20 persons;

•

at least 75 per cent of the amount of any dividend paid by the company during the year was paid to no more than 20 persons; and

•

if no dividend was paid by the company during the year - the Commissioner is of the opinion that, if a dividend had been paid by the company during the year, at least 75 per cent of the amount of the dividend would have been paid to no more than 20 persons.

7.29 By subsection 272-105(1) of Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936) a unit trust is a widely held unit trust if it is a fixed trust that is a unit trust and is not closely held. In accordance with subsection 272-105(2) a trust is closely held if:

•

an individual has, or up to 20 individuals have between them; or

•

no individual has, or no individuals have between them,

directly or indirectly and for their own benefit, fixed entitlements to a 75 per cent or greater share of the income of the trust.

Capital protected borrowings

7.30 The most common types of CPB arrangements are instalment warrants and capital protected equity loans. However, there are other arrangements or techniques which can protect an investor's capital.

7.31 Both instalment warrants and capital protected equity loans involve the purchase of shares with either a limited recourse loan or a full recourse loan and a put option over the shares acquired. The shares are also used as security for the loan.

Instalment warrants

7.32 Instalment warrants are warrants purchased in instalments and are listed on the ASX. This first instalment will generally reflect the price of the underlying share, pre-paid interest and borrowing costs and depending on the structure of a particular instalment warrant, may include an amount for acquiring a put option over the underlying shares. The underlying share is purchased and held on trust for the investor by the warrant lender using the first instalment and loan funds provided by the warrant lender.

7.33 The writer of the warrant lends the second instalment (or the exercise price) to the borrower in the form of a limited recourse loan. The lender charges interest on the loan, which is pre-paid (generally up to 12 months but may be up to 18 months) until expiry and is a part of the price of the first instalment. An instalment warrant is usually geared at between 30 and 80 per cent - that is, the initial instalment is between 70 per cent and 20 per cent of the cost of the shares.

7.34 The investor obtains the share by paying a second and final instalment which pays off the remaining loan amount (and interest). Where the value of the share is less than the amount payable for the second instalment, the investor can put the share to the lender and in return for an amount equal to the second instalment payment, thus limiting their losses to the amount of the first instalment.

7.35 An investor in an instalment warrant will receive any dividends paid and benefit from any franking credits on the underlying shares during the term of the instalment warrant.

Example 7.6: Instalment warrant

An instalment warrant with a term of 12 months is issued over a portfolio of shares worth $100,000. The holder pays the warrant lender $49,000 and the warrant lender provides limited recourse finance to the holder for the remaining $51,000. In six months time, the holder pays the warrant lender $56,100 ($51,000 + interest for six months at 20% p.a., equal to $5,100).

Other capital protected borrowings

Capital protected equity loans

7.36 A capital protected equity loan is typically a limited or non-recourse loan from a lender, with a term of up to five years that is used to acquire shares, units or stapled securities. The loan may be an 'interest only' style loan. The capital protection is provided by the limited or non-recourse nature of the loan or if the loan is fully recourse the capital protection is provided by an actual put option over the share portfolio. If the borrower defaults on the loan the lender will be able to enforce a mortgage over the shares, units or stapled securities. However, if the borrower defaults the capital protection feature of the arrangement ceases.

Capital protection provided via dynamic hedging / portfolio insurance

7.37 Another type of arrangement is one which gives an investor the option to borrow 100 per cent of the funds and 100 per cent capital protection through the purchase of a put option and access to a number of managed funds. However, as these funds are managed using an asset management technique called dynamic hedging or portfolio insurance the value of the put option is arguably very small and would only be exercised if the dynamic hedging did not provide capital protection because of market gapping (ie, where there are large unsystemic falls in the price of an asset).

CPBs entered into before 1 July 2007

7.38 Division 247 only applies to CPBs or extensions of CPBs, entered into before 1 July 2007, where the share, unit in a unit trust or stapled security is listed for quotation in the official list of an approved stock exchange. [ Schedule 7, item 1, subsection 247-15(4 )]

7.39 Such CPBs, or extensions of existing CPBs entered into on or after 9.30 am, by legal time in the Australian Capital Territory, on 16 April 2003 and before 1 July 2007 will be subject to the interim methodology contained in the Income Tax (Transitional Provisions) Act 1997. For further details on transitional provisions refer to paragraphs 7.80 to 7.111.

CPBs entered into before 1 July 2007 and extended after 1 July 2007

7.40 Where the CPB is entered into or extended on or after 1 July 2007, or is extended after that time, Division 247 will apply to CPBs with both listed and widely held unlisted shares and will be subject to the ongoing methodology to apportion the cost of the arrangement (see paragraphs 7.42 to 7.76). [ Schedule 7, item 1, subsection 247-15(4 )]

CPBs where a share or stapled security is acquired under an employee share scheme

7.41 This measure is not to apply to CPBs under which a company provides limited recourse loans to employees to buy shares or stapled securities in their employer companies. [ Schedule 7, item 1, subsection 247-15(3 ]

Capital protection taken to be a put option

Application to a borrower

7.42 The amendments apply to a borrower:

•

if the borrower has an excess using the method statement in subsection 247-20(3) for a CPB entered into or extended on or after 1 July 2007; or

•

the borrower has an amount that is reasonably attributable to the capital protection for a CPB, or an extension of a CPB, entered into on or after 9.30 am, by legal time in the Australian Capital Territory, on 16 April 2003 and before 1 July 2007.

[ Schedule 7, item 1, subsection 247-20(1 ]

CPBs entered into on or after 16 April 2003 and before 1 July 2007

7.43 For CPBs or extensions of existing CPBs, entered into, on or after 16 April 2003 and before 1 July 2007 the amount that is reasonably attributable to capital protection is determined under Division 247 of the Income Tax (Transitional Provisions) Act 1997. [ Schedule 7, item 1, subsection 247-20(2 )]

Amounts reasonably attributable to capital protection for CPBs entered into or extended on or after 1 July 2007

7.44 For CPBs entered into on or after 1 July 2007 the amount that is reasonably attributable to capital protection is calculated using three steps:

•

The first step is to calculate the total amount incurred by the borrower under or in respect of the CPB for the income year ignoring amounts that are not in substance for capital protection or interest.

•

The second step is to apply the Reserve Bank's indicator interest rate for variable personal unsecured loans that is specified for CPBs based on a fixed or a variable rate.

•

Where the amount under Step 1 exceeds the amount under Step 2 the excess is reasonably attributable to the capital protection for the income year.

[ Schedule 7, item 1, subsection 247-20(3 )]

Step 1: Total amounts incurred by a borrower under a CPB

7.45 An amount incurred by a borrower under a CPB typically may include both the cost of servicing the loan, usually referred to as 'interest' and the cost of the capital protection component. However, it excludes amounts that are not, in substance, amounts incurred for capital protection or interest. An amount incurred by a borrower which is in substance interest includes in substance, amounts incurred which are effectively the same as interest such as a discount expense. [ Schedule 7, item 1, subsection 247-20(3 ), Step 1 ]

7.46 The cost of the protection component may be specified separately from the cost of servicing the loan. Alternatively, the protection component (in whole or in part) may be included in the cost of servicing the loan, for example, interest.

7.47 In the case of a CPB that is acquired in the primary market prior to listing on the ASX, the cost of the protection component is typically specified separately from the cost of servicing the loan. In the case of other types of CPB, the cost of the protection component is usually included as part of the so called 'interest' cost of servicing the loan.

7.48 In the event that the cost of the protection component is included in the cost of servicing the loan, the cost of servicing the loan is typically materially higher than the cost of servicing a full recourse loan.

7.49 The following amounts, to the extent that they are effectively not incurred for capital protection or interest are not in substance amounts for capital protection or in substance amounts for interest and thus are not taken into account in determining the total amount incurred by the borrower for an income year. They are:

•

a repayment of the principal borrowed; or

•

any of the following:

•

an application fee;

•

a brokerage commission;

•

stamp duty or any other tax or charge imposed by a State or Territory;

•

a charge imposed by an approved stock exchange;

•

a fee to extend or vary the borrowing; or

•

any other amount paid to enter into, vary, renew, transfer or terminate the arrangement;

•

a fee for the management of the borrowing or the arrangement; or

•

a fee, charge or other amount similar to any of the above.

7.50 The requirement to ignore amounts that are not in substance for capital protection or interest is to prevent CPBs avoiding the measures as the result of issuers shifting capital protection costs to other deductible costs under CPBs, such as borrowing and management fees. For example, if an amount that is really for capital protection is included as part of the management fee then that amount will be excluded to the extent that it is a fee for management rather than a fee for capital protection. The amount that is really for capital protection will be taken into account under Step 1.

Step 2: Total interest incurred at personal unsecured loan rate

7.51 When applying Step 2, regard is to be had to the pricing, terms and conditions of the loan or credit provided under the capital protected borrowing. In effect Step 2 assumes that the loan or credit provided is identical to that under the CPB except that the interest rate is the Reserve Bank's Indicator Rate for Personal Unsecured Loans - Variable Rate.

7.52 This means that in determining the total interest that would have been incurred for the income year, the timing and relative size of the amounts incurred in accordance with terms and conditions specified under the CPB will be relevant in determining the total interest that would have been incurred for that income year.

CPB is at a fixed rate for the term of the CPB

7.53 Where a CPB is at a fixed rate for the term of the borrowing the second step is to calculate the total interest that would have been incurred on the outstanding loan principal for the income year using the Reserve Bank's Indicator Rate for Personal Unsecured Loans - Variable Rate at the time the first amount was incurred under Step 1, to the amount of the outstanding loan principal. [ Schedule 7, item 1, subsection 247-20(4 )]

CPB is at a variable rate for the term of the CPB

7.54 Where a CPB is at a variable fixed rate for the term of the borrowing the second step is to calculate the total interest that would have been incurred on the outstanding loan principal for the income year using the average of the published Reserve Bank's Indicator Rate for Personal Unsecured Loans - Variable Rate for the term of the borrowing. [ Schedule 7, item 1, subsection 247-20(5 )]

CPB is at a fixed rate for part of the term

7.55 Where a CPB is at a fixed rate for part of the term of the borrowing (and at a variable rate for the remainder of the term of the borrowing) the second step is to calculate the total interest that would have been incurred for the income year by using the methodology for the fixed rate for that part of the term that the rate is fixed and the methodology for the variable rate for that part of the term that the rate is variable. [ Schedule 7, item 1, subsections 247-20(4 ) and ( 5 )]

7.56 The indicator interest rates specified are those that have been used by the Australian Taxation Office (ATO) prior to Firth's case for the purposes of apportioning costs of a CPB between the interest and the capital protection. These interest rates are published monthly by the Reserve Bank in the RBA Statistical Bulletin Table F5 which may be accessed via the Reserve Bank's website http://www.rba.gov.au.

Example 7.7: Interest paid in advance

Jack, a public servant, enters into a CPB on 28 June 2007 with a term of three years under which he borrows $100,000 under a limited recourse loan. The Reserve Bank personal unsecured loan variable rate is at 12.4 per cent per annum at that time. The loan principal of $100,000 is repayable at the end of the CPB. The interest rate charge on the loan is fixed at 15 per cent per annum which is paid at the start of every 12 months. The first interest payment of $15,000 is paid on 28 June 2007.

In applying Step 2 it is assumed that the notional loan is the same as in the actual loan that Jack has and which is reflected in the calculations in Step 1. However, the interest rate to be used in Step 2 is the personal unsecured rate of 12.4 per cent per annum. This means that the notional interest is assumed to be paid at the same time (ie, 28 June 2007) on the same outstanding principle ($100,000) for the same period and the same relative amount (ie, 12 months) but at 12.4 per cent per annum. The amount taken into account under Step 1 is $15,000 (ie, $100,000 x 15% p.a.) and the Step 2 amount for the 2007 income year is $12,400.

Less than 100 per cent of borrowing used to acquire beneficial interest

7.57 Where less than 100 per cent of the amount borrowed is used to acquire or is secured by shares, units in unit trust or stapled securities the amounts incurred based on the amount borrowed (eg, 'interest'), are apportioned. [ Schedule 7, item 1, subsection 247-10(1 )]

Example 7.8: Only part of borrowing used for CPB

Under a CPB Richard borrows $80,000 but only $50,000 is used to acquire shares, units in a unit trust or stapled securities. If the amount incurred, or part of the amount incurred, is calculated by reference to the amount borrowed this calculation, such as for Steps 1 and 2, will use $50,000 rather than $80,000.

Outstanding loan balance

7.58 Where the amount incurred is based upon the loan principal, the relevant loan principal will be the loan principal outstanding at the time the amount is incurred.

Example 7.9: Outstanding loan or credit balance

Under a CPB Tom borrows $100,000 at 15 per cent per annum fixed for three years. The Reserve Bank Personal Unsecured Loans - Variable Rate at the time the CPB was entered into was 12.4 per cent per annum. The capital protected amount for the first year will be $2,600. At the end of year 1 Tom pays $15,000 and repays $40,000 of the principal. As $60,000 is the outstanding loan principal for the second year the capital protected amount is $1,560 ($60,000 x 15% - $60,000 x 12.4%).

Step 3: Excess reasonably attributable to capital protection

7.59 In accordance with Step 3 the excess of the Step 1 amount over the Step 2 amount is the amount which is reasonably attributable to the capital protection for the income year.

Example 7.10: Benchmark interest rate cap

John, a retiree, enters into a CPB with a term of one year under which he borrows $100,000 under a limited recourse loan. The Reserve Bank's Indicator Rate for Personal Unsecured Loans - Variable Rate is 12.4 per cent per annum at the time the CPB is entered into. The loan principal of $100,000 is repayable at the end of the CPB. Under the limited recourse loan the beneficial interest in the share portfolio may be given to the lender in full satisfaction of the loan principal. The interest rate charge on the loan is 20 per cent per annum.

The amount incurred by John on the CPB is $20,000 ($100,000 x 20%) for the income year. The interest that would have been payable using the Reserve Bank's Indicator Rate for Personal Unsecured Loans - Variable Rate is $12,400 ($100,000 x 12.4%). Accordingly, John is taken to have paid $7,600 ($20,000 - $12,400) of the $20,000 for a put option.

7.60 A put option is to be taken to exist and be issued at the commencement of the period for which capital protection is provided and to cease to exist when the capital protection is no longer provided, that is, when it expires or is exercised. The amount that is reasonably attributable to capital protection is deemed to be incurred by the borrower (and received by the lender or another entity) for a put option or put options.

7.61 The pricing, terms, and conditions of the CPB will need to be examined to determine if there will be deemed to be more than one put option. For instance, if there is more than one specified date upon which a borrower may require or the lender is obliged to acquire the beneficial interest in the underlying asset there will be taken to be a put option for each exercise date. However, if a borrower may require the lender to acquire the beneficial interest in the underlying asset at any time up to and including exercise date or the lender is obliged to acquire the beneficial interest in the underlying asset at any time up to and including exercise date, there will be take to be a single put option.

Forms of capital protection

7.62 As noted above, capital protection may be provided in different forms including a separately identifiable put option, an embedded put option (eg, a put option that is not separately identifiable from a limited recourse loan), a synthetic put option or a dynamically replicated put option.

Capital protection under a CPB

7.63 Capital protection may be held by the borrower or within the CPB arrangement, for example, by the trustee of a trust holding where the beneficial interest is in shares, units in a unit trust or stapled securities.

7.64 The amendments will also apply where under the arrangement, capital protection is provided by an entity other than the lender. This requirement is designed to prevent avoidance of the amendments by separating the provision of capital protection from the provision of finance under the CPB. [ Schedule 7, item 1, subsection 247-10(1 )]

Amounts incurred reasonably attributable to capital protection

7.65 Where section 247-20 applies to a borrower:

•

for CPBs subject to the ongoing methodology the excess from the method statement in subsection 247-20(3); or

•

for CPBs subject to the interim methodology the amount reasonably attributable to capital protection under the interim methodology,

is reduced by any amount incurred under the CPB for an explicit put option and is taken to be incurred only for a put option granted by the lender or another entity under the CPB [ Schedule 7, item 1, subsection 247-20(6 )]. If the excess reduced by any amount incurred for an explicit put option is negative no amount is taken to be incurred for a deemed put option.

7.66 So much of each amount that a borrower incurs under or in respect of a CPB, as is included as the borrower's excess or as reasonably attributable to capital protection is taken to be incurred for a put option only.

7.67 An explicit put option is an actual put option rather than a deemed put option. A CPB may have an explicit put option that provides little or no capital protection where capital protection is provided by another form of capital protection such as dynamic hedging.

Example 7.11: Steps 1 to 3

A CPB with a term of three years is entered into on 1 January 2008 and will end on 1 January 2011. The Reserve Bank personal unsecured loan fixed rate is 13 per cent per annum. at the time the CPB is entered into. The amount borrowed is $100,000 which is repayable at maturity and the 'interest' charged is fixed at 16 per cent per annum, which is payable monthly in arrears. The amount of capital protection is $3,000 per annum (ie, 3% p.a. x $100,000) and interest is $13,000 per annum.

For the income year 1 July 2007 to 30 June 2008 the amount incurred under Step 1 is $8,000 (ie, $100,000 x 16% x 0.5) while the amount incurred under Step 2 is $6,500 (ie, $100,000 x 13% x 0.5) thus the capital protection is $1,500 (ie, $8,000 - $6,500). The amount of the interest deduction is $6,500 (ie, $8,000 - $1,500).

For the income year 1 July 2008 to 30 June 2009 the amount of capital protection is $3,000 and the amount of interest deduction is $13,000.

For the income year 1 July 2009 to 30 June 2010 the amount of capital protection is $3,000 and the amount of interest deduction is $13,000.

For the income year 1 July 2010 to 30 June 2011 the amount incurred under Step 1 is $8,000 (ie, $100,000 x 16% x 0.5) while the amount incurred under Step 2 is $6,500 (ie, $100,000 x 13% x 0.5) thus under Step 3 the capital protection is $1,500 (ie, $8000 - $6500). The amount of the interest deduction is $6,500 (ie, $8,000 - $1500).

Number of put options

7.68 Where the capital protection under a CPB may be exercised on more than one occasion over the term of the CPB there is taken to be a put option for each of those occasions. So much of each amount a borrower incurs that is reasonably attributable to each put option is taken to be incurred for that put option. [ Schedule 7, item 1, subsection 247-25(1 )]

Example 7.12: Three put options

A CPB has a term of three years. Capital protection may be invoked at the end of each year. Accordingly, there will be taken to be three put options with one put option exercisable at the end of each year.

European style capital protection / embedded options

7.69 However, where the capital protection under a CPB may be exercised at any time up until and including the end of a period, for which there is capital protection, the capital protection is taken to give rise to a single put option for that period. [ Schedule 7, item 1, subsection 247-25(2 )]

Example 7.13: Single put option

A CPB has a term of three years. Capital protection may be invoked on any day up until and including the last day. Accordingly, there will be taken to be a single put option with a term of three years.

Exercise or expiry of deemed put option

Deemed exercise of put option

7.70 If the capital protection under a CPB is invoked, the borrower is taken to have exercised the put option and any interest in a share, unit in a unit trust or a stapled security is taken to have been disposed of by the borrower as a result of the exercise of the put option. [ Schedule 7, item 1, subsection 247-30(1 )]

7.71 The capital protection under a CPB may be invoked by either the borrower or the lender or another entity under the arrangement or may be automatic or self-executing.

CGT consequences of exercise

7.72 Under these amendments an embedded or replicated put option under a CPB is to be treated as though it were an actual put option, acquired by the borrower, for the purposes of the income tax law, that is, a separately identifiable put option.

7.73 A put option may be on revenue account or on capital account (depending on such factors as, for example, the nature of the business of the taxpayer). Where a put option is on capital account the premium is not an allowable deduction to the grantee nor is it assessable income of the grantor. Conversely, where a put option is on revenue account the premium may be an allowable deduction to the grantee and it will be assessable income of the grantor.

7.74 If the put option is exercised and as a result the borrower has transferred a share, unit in a unit trust or stapled security by exercising the deemed put option there is a disposal (including for the purpose of CGT event A1 ) by the borrower.

Deemed expiry of put option

7.75 On the other hand, if the capital protection under a CPB is not invoked during the term or at the end of the term of the CPB the put option is taken to have expired. [ Schedule 7, item 1, subsection 247-30(2 )]

CGT consequences of expiry

7.76 If the put option expires then CGT event C2 will happen to the grantee. The grantee will make a capital loss equal to the amount of the premium.

Example 7.14: CPB post-1 July 2007

John enters into a capital protected equity loan for a term of 10 years. Under this arrangement John borrows $100,000, which is repayable at maturity, and invests in a $100,000 share portfolio. The repayment of the loan principal may be fully satisfied by giving the share portfolio to the lender. John pays fixed 'interest' of 18 per cent per annum at the start of each year. The Reserve Bank's Indictor Rate for Personal Unsecured Loans - Fixed Rate at the time the CPB was entered into was 12.25 per cent per annum. Accordingly, the amount that is reasonably attributable to capital protection for each income year is $5,750 (ie, 18% x $100,000 - 12.25% x $100,000).

Application and transitional provisions

Interim apportionment methodology

7.77 The interim apportionment methodology is to apply to those CPBs including extensions of existing arrangements entered into on or after 9.30 am, by legal time in the Australian Capital Territory, on 16 April 2003 and before 1 July 2007. [ Schedule 7, item 2, section 247-5 of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.78 However, the interim apportionment methodology will only apply to CPBs entered into before 1 July 2007 where the beneficial interest acquired under the CPB is a share, unit in a unit trust or stapled security that is listed for quotation in the official list of an 'approved stock exchange'. [ Schedule 7, item 1, subsection 247-15(2 )]

Example 7.15: Extension after 16 April 2003 and pre-1 July 2007

On 30 April 2000 Bill entered into a CPB for three years to acquire ASX-listed shares. He extended the CPB on 29 April 2003 for another two years. The extension of the CPB would be subject to the interim methodology. The relevant term of the extension of the CPB would be two years.

Example 7.16: Extension after 1 July 2007

On 29 June 2006, Bill took out a CPB for two years to acquire widely held unlisted shares. He extended the CPB for another three years on 28 June 2008.

The initial CPB would not be subject to the interim methodology as it was used to acquire unlisted shares. However, the extension of the CPB would be subject to the ongoing methodology in Division 247 from 28 June 2008 as the latter applies to the acquisition of widely held unlisted shares. The relevant term of the extension of the CPB would be three years.

7.79 In accordance with subsection 995-1(1) 'approved stock exchange' has the meaning given by section 470 of the ITAA 1936. In accordance with section 470 of the ITAA 1936, approved stock exchange means:

•

a stock exchange named in regulations made for the purposes of this definition; or

•

until regulations are so made - a stock exchange named in Schedule 7.

Schedule 12 of the Income Tax Regulations 1936 contains the list of approved stock exchanges.

7.80 The interim apportionment methodology will not apply to CPBs where a share or stapled security is acquired under an employee share scheme. [ Schedule 7, item 1, subsection 247-15(3 )]

7.81 There are two apportionment methodologies under the transitional provisions. The first is for CPBs listed on the ASX with explicit put options. The second is for all other CPBs including CPBs not listed on the ASX (but listed on another approved stock exchange) and CPBs listed on the ASX without explicit put options.

Instalment warrants listed on ASX with explicit put option

First interim methodology

7.82 The first methodology applies to CPBs that are instalment warrants that are listed on the ASX and contain explicit put options that allows the underlying investment (listed shares, listed units in a unit trust or listed stapled securities) to be sold for at least the amount borrowed (or credit provided) and has a separate price for the explicit put option that reasonably reflects its market value. [ Schedule 7, item 2, subsection 247-10(1 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.83 The only CPB currently listed on the ASX is an instalment warrant. An instalment warrant is a financial arrangement that:

•

is tradeable on a stock-market and purchased for consideration;

•

confers beneficial, but not legal, ownership of an underlying asset (which is usually a market traded share) to the holder (and therefore entitles the holder immediately to the benefits of ownership of the underlying asset); and

•

gives the holder the right, but not the obligation, to become the legal owner of the underlying asset by making an additional payment (which may be at a specified time, or at any time in the life of the warrant).

7.84 Instalment warrants may run for a term of several years and have payments due annually representing the following year's interest and capital protection expenses. The dates on which these payments are due are known as reset dates.

7.85 Instalment warrants can be acquired in the primary market (ie, directly from the lender, usually as part of a public offer). Investors who acquire an instalment warrant in the primary market can subsequently trade this warrant with other investors (ie, sell the instalment warrant on the secondary market).

7.86 In the case of instalment warrants acquired in the primary market, the cost of protection component has historically been identified separately from the cost of servicing the loan component, and the lender of the instalment warrant informs the person acquiring the warrant what the cost of the protection component is. Similarly, the part of the payment made at the reset date which is attributable to the cost of capital protection is also usually identified by the lender.

Instalment warrant acquired on a primary market

7.87 If an amount is incurred to acquire the CPB in the primary market or at a reset date of the borrowing under the CPB the amount that is reasonably attributable to capital protection is the amount specified by the lender of the CPB as the cost of the put option. [ Schedule 7, item 2, subsection 247-10(2 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

Example 7.17: Instalment warrant acquired on a primary market

James acquires an instalment warrant with a term of three years on the primary market. The instalment warrant is issued over a portfolio of shares worth $100,000. At the time the instalment warrant is entered into James pays the warrant issuer $50,000 for the share portfolio and the warrant issuer provides limited recourse finance to James for the remaining $50,000 at an interest rate of 10 per cent per annum. A year and a half later James pays the warrant issuer $64,100 ($50,000 + prepaid interest for 18 months at 10% p.a. on $50,000 ie, $7,500) + (borrowing fees of $6,600 of which $4,400 is the cost of the put option). The amount that is reasonably attributable to capital protection is $4,400.

Instalment warrants acquired on a primary market with put cost that does not reasonably reflect market value

7.88 Where an instalment warrant is acquired on the primary market but the put option has a separate cost that does not reasonably reflect the market value of the cost, subsection 247-10(2) does not apply [ Schedule 7, item 2, subsection 247-10(2 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]. Rather, the cost of capital protection will be calculated in accordance with section 247-15 [ Schedule 7, item 2, section 247-15 of the Income Tax ( Transitional Provisions ) Act 1997 ].

Unlisted instalment warrants

7.89 An unlisted instalment warrant will not satisfy section 247-10 and thus the cost of capital will be calculated in accordance with section 247-15. [ Schedule 7, item 2, section 247-15 of the Income Tax ( Transitional Provisions ) Act 1997 ]

Example 7.18: Unlisted instalment warrants

On 1 July 2004 Richard acquired 1,000 unlisted instalment warrants over shares in ASX-listed ABC Ltd. Each unlisted instalment warrant had a term of three years and an initial payment of $2 and a final payment (loan amount) of $3. The interest rate on the limited recourse loan was 8.9 per cent per annum and the first year's interest payment was included in the initial payment. The lender's recourse is only to the underlying ABC Ltd shares. There is no separate put option under the unlisted instalment warrant arrangement. The Reserve Bank's Indicator Rate for Personal Unsecured Loans - Fixed Rate at the time the CPB was entered into was 12.1 per cent per annum.

The amount that is reasonably attributable to the capital protection provided under the unlisted instalment warrant would be worked out under the interim methodology. As the instalment warrant is not listed on the ASX the amount that is reasonably attributable to the capital protection for the 2005 financial year is the greater of the amount worked out under the indicator method and the percentage method as follows.

The total amount incurred for capital protection and interest is $267 (1,000 x ($3 x 0.089). The amount worked out using the indicator rate is $363 (1,000 x ($3 x 0.121)). As there is no excess, no amount is reasonably attributable to capital protection under the indicator method.

As the term of the loan is three years the relevant percentage is 20 per cent and the amount worked out under the percentage method is $53.40 ($267 x 0.20).

As the amount worked out under the percentage method, $53.40, is the greater amount, this is the amount that is reasonably attributable to the capital protection for the 2005 financial year.

Instalment warrant acquired on a secondary market

7.90 In the case of the acquisition of an instalment warrant which contains a put option in the secondary market, the capital protection amount is determined as a residual amount - which is intended to reflect the difference between the amount paid for the security and its value without the protection.

7.91 The calculations work by taking the difference between the market value of the underlying security and the borrowing amount on the warrant, adding the market value of the warrant (which, as this is a transaction on the stock market will also be the price paid) and then subtracting that portion of the market value which is a payment for pre-paid interest.

7.92 The portion of a payment is referred to as being attributable to pre-paid interest as this is a commonly accepted term in the markets with an understood meaning. Pre-paid interest is an optional early payment of interest that is paid before there is a contractual obligation to pay the interest, for example, it is paid at the start of a CPB but it is not due until the middle of the term of the CPB.

7.93 Where a CPB is acquired on the secondary market the amount that is reasonably attributable to capital protection is the amount determined under subsection 247-10(4) or (5) of the Income Tax (Transitional Provisions) Act 1997. [ Schedule 7, item 2, subsection 247-10(3 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

Market value of the underlying asset is greater than the amount of borrowing

7.94 If the market value of the underlying assets (listed shares, listed units in a unit trust or listed stapled securities) is more than the amount of the borrowing the amount that is reasonably attributable to capital protection is:

•

the market value of the CPB;

plus

•

the amount of the borrowing or credit;

less

•

the market value of the underlying securities and so much of the amount incurred as is attributable to pre-paid interest.

[ Schedule 7, item 2, subsection 247-10(4 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

Market value of the underlying asset is equal to or less than the amount of borrowing

7.95 If the market value of the underlying assets (listed shares, listed units in a unit trust or listed stapled securities) is equal to or less than the amount of the borrowing the amount that is reasonably attributable to capital protection is:

•

the market value of the CPB;

less

•

any pre-paid interest.

[ Schedule 7, item 2, subsection 247-10(5 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.96 If the amount worked out in either subsection 247-10(4) or (5) is negative, the amount that is reasonably attributable to capital protection is nil. [ Schedule 7, item 2, subsection 247-10(6 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

Example 7.19: Instalment warrant acquired on a secondary market

Assume that an ordinary share in ABC Ltd, a listed company has a market value of $13.30. An instalment warrant has been issued over it. It has a maturity date of 25 December 2009. The current market price of the instalment warrant is $1.09. The exercise price of the instalment warrant is $15.55 and the interest rate on the loan is 8.5 per cent per annum. Tony acquires the instalment warrant today on the above terms.

Pre-paid interest = $15.55 x (140/365) x 8.5% = $0.51

The market value of the underlying security ($13.30) is less than the amount of the borrowing ($15.55). Tony calculates the cost of the put option of $0.58 by deducting the prepaid interest ($0.51) from the market value of the instalment warrant ($1.09). Accordingly, Tony's cost of capital protection is $0.58.

Other CPBs

Second interim methodology

7.97 The second interim methodology will apply to CPBs that are not subject to the first methodology. These CPBs will be those CPBs not listed on the ASX or those listed on the ASX but without an explicit put option or those listed on the ASX with an explicit put option but which do not have a separate price that reasonably reflects the value of that put option.

7.98 This interim methodology consists of two different calculations - one (the indicator method) which caps the percentage of interest deductible in an income year at the relevant Reserve Bank indicator rate, and the other (the percentage method) which carves out an appropriate portion of the amounts incurred as capital protection amounts for payments made at rates close to or below the indicator level. [ Schedule 7, item 2, subsection 247-20(1 ) and section 247-25 of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.99 Under the second interim methodology the amount reasonably attributable to capital protection for an income year is the greater of the amount under the indicator method (in section 247-20) and the percentage method (in section 247-25). If these amounts are the same this amount is the amount that is reasonably attributable to capital protection for the income year. [ Schedule 7, item 2, subsection 247-15(1 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.100 If a CPB involves more than one amount incurred in an income year the total amount that is reasonably attributable to capital protection for the year is distributed pro-rata between those amounts incurred. [ Schedule 7, item 2, subsection 247-15(2 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

Indicator method

7.101 Under the indicator method the total amount that is reasonably attributable to capital protection is the amount by which the total amount incurred by the borrower under a CPB for the year exceeds the total interest payable on an equivalent borrowing at the relevant indicator rate. [ Schedule 7, item 2, subsection 247-20(1 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.102 Where a CPB has significant payments based on a variable interest rate, the relevant indicator rate is the Reserve Bank's Indicator Rate for Personal Unsecured Loans - Variable Rate at the time the amount was incurred. For other CPBs the relevant indicator rate is the Reserve Bank's Indictor Rate for Personal Unsecured Loans - Fixed Rate at the time the CPB was entered into. [ Schedule 7, item 2, subsection 247-20(2 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.103 It is intended that the concept of 'equivalent loan' here will, in particular, ensure that the interest payment schedule which applies to the CPB also applies in calculating the payments that would have been made at the indicator rate. So if, in a particular income year, interest is only paid for six months of the term of the borrowing then the comparable indicator interest will be the interest for a six month period. Similarly if, in the relevant income year, three years worth of interest is pre-paid, then three years worth of interest at the indicator rate will be used for the comparison. [ Schedule 7, item 2, subsection 247-20(3 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

7.104 As noted above, the indicator rates are published monthly by the Reserve Bank in their Statistical Bulletin Table F5 which may be accessed via the Reserve Bank's website http://www.rba.gov.au. The fixed rate is to be used if the rate specified in the CPB is fixed while the variable rate to be used if the rate specified in the CPB is variable. Where the variable indicator rate is to be used, the rate used is that current at the time the corresponding amount is incurred. Where a fixed rate is to be used, the relevant rate is the rate current at the time the CPB was entered into.

Example 7.20: Amount under the indicator method

Rhea enters into a capital protected equity loan for a term of three years. Under this arrangement Rhea borrows $100,000, which is repayable at maturity, and invests in a $100,000 share portfolio. The repayment of loan principal may be fully satisfied by giving the share portfolio to the lender. Rhea pays fixed 'interest' of 20 per cent per annum at the start of each year. The Reserve Bank's Indicator Rate for Personal Unsecured Loans - Fixed Rate at the time the CPB was entered into was 12.25 per cent per annum. Accordingly, the amount under the indicator method that is reasonably attributable to capital protection for each income year is: $7,750 (ie, 20% x $100,000 - 12.25% x $100,000).

Percentage method

7.105 Under the percentage method the cost of the protection component is a specific percentage of the amount incurred - where the percentage to be applied depends on the term of the CPB. The percentage to be used decreases with the term of the CPB.

Example 7.21: Amount under the percentage method

Further from Example 7.20, the total amount Rhea incurs under the capital protected equity loan is $20,000 each income year. Under the percentage method the amount incurred that is reasonably attributable to capital protection each year is $4,000 (ie, 20% x $20,000).

7.106 In calculating the total amount that is reasonably attributable to capital protection, the term of the CPB is rounded up to the next higher number of years. The total amount incurred by the borrower under the CPB for capital protection in an income year is:

•

40 per cent of that total amount if the term is one year or shorter;

•

27.5 per cent of that total amount if the term is more than one year but not longer than two years or;

•

20 per cent of that total amount if the term is more than two years but not longer than three years;

•

17.5 per cent of that total amount if the term is more than three years but not longer than four years; or

•

15 per cent of that total amount if the term is longer than four years.

[ Schedule 7, item 2, subsection 247-25(2 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

Example 7.22: Rounding up of terms under the percentage method

A CPB has a term of 2.5 years, which rounds up to three years. Accordingly, the total amount incurred by the borrower in an income year will be 20 per cent of that total amount.

Comparison of amounts under the indicator method and the percentage method

7.107 The total amount that is reasonably attributable to capital protection for the income year is the greater of the amounts under the indicator method and the percentage method. If these amounts are equal this amount is taken to be the total amount that is reasonably attributable to capital protection for the income year. [ Schedule 7, item 2, subsection 247-15(1 ) of the Income Tax ( Transitional Provisions ) Act 1997 ]

Example 7.23: Comparison of amounts

Following on from Examples 7.20 and 7.21, the amount reasonably attributable to capital protection is $7,750 as this is greater than $4,000.

Example 7.24: Less than 100 per cent capital protection

On 28 June 2004 Shirley took out a $100,000 CPB for two years to acquire 100,000 ASX-listed stapled securities with a market value of $100,000. The loan application fee was 1 per cent. The interest rate on the CPB was 17 per cent fixed per annum. The terms of the CPB provided for a put option but there was no separate charge for the put option. Shirley prepaid interest for the 2004-05 financial year on 28 June 2004.

Under the terms of the put option, the exercise price was set at $0.60 per stapled security. This would not allow Shirley to put back the shares for the full value of the loan.

The Reserve Bank's Indicator Rate for Personal Unsecured Loans - Fixed Rate (indicator rate) on 28 June 2004 was 12.4 per cent.

As the CPB does not satisfy the conditions in section 247-10, the total amount that is reasonably attributable to the capital protection for the 2004-05 financial year is the greater of the amount worked out under the indicator method and the percentage method as follows.

Total amount incurred for capital protection and interest is $17,000 ($100,000 x 0.17). The amount incurred using the indicator rate is $12,400 ($100,000 x 0.124).

The excess is $4,600 ($17,000 - $12,400).

As the term of the loan is two years, the relevant percentage for the percentage method is 27.5 per cent and amount worked out under the percentage method is $4, 675 ($17,000 x 0.275).

As the amount worked out under the percentage method, $4,675, is the greater amount, this is the amount that is reasonably attributable to the capital protection for the 2004-5 financial year.

Consequential amendments

7.108 Subsection 995-1(1) of the ITAA 1997 will be amended to include references to capital protected borrowing and capital protection. [ Schedule 7, Part 2, items 2 and 3 ]

Index

Schedule 1: Small business relief for CGT events

Schedule 2: Interest withholding tax

Schedule 3: Streamline gift fund and integrity arrangements for deductible gift recipients

Schedule 4: Deductible gift recipient extensions

Schedule 5: Effective life of tractors and harvesters

Schedule 6: Farm management deposits

Schedule 7: Capital protected borrowings