House of Representatives

Explanatory Memorandum

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

Chapter 3 - Other applications of the debt/equity test

Outline of chapter

3.1 This chapter describes the other places in the income tax law where the new debt and equity definitions are used.

Detailed explanation of new law

Where are the new debt and equity definitions used in the income tax law?

3.2 The new definition of a debt interest is intended to be used in the proposed new thin capitalisation regime (see paragraph 3.23). However, this bill does not purport generally to extend the new definition elsewhere in the income tax law.

3.3 The new definition of equity interests and related concepts of equity holders and non-share dividends are generally used in all the provisions of the income tax law dealing with the taxation of returns on financing instruments, including the imputation provisions. However, because non-share equity interests are rarely relevant in determining ownership of companies, the new definition and its related concepts are not used in provisions relating to the ownership of companies, including:

•

provisions governing the transfer and use of losses;

•

grouping concessions (e.g. the provision of the intercorporate dividend for unfranked dividends paid within a company group);

•

the definition of public and private companies;

•

the CFC and FIF provisions; and

•

sections 23AJ, 23AI and 23AK of the ITAA 1936.

3.4 An exception is made in relation to co-operative companies that are eligible for tax concessions under Division 9 of Part III of the ITAA 1936. These companies are not required to frank non-share dividends, and will not lose their concessional tax treatment merely by issuing non-share equity interests. [Schedule 1, item 94, paragraph (ga) of the definition of frankable dividend in section 160APA]

3.5 Tables 3.1 and 3.2 summarise the provisions of the income tax law where the new definition of equity interest and its related concepts apply. Provisions dealing with international taxation to which the new debt/equity rules apply are discussed immediately after the tables.

Table 3.1: Provisions of the ITAA 1936 to which the new definition of equity interest and its related concepts apply

Application of debt/equity concepts to provisions relating to international taxation

How do the debt/equity rules apply to the withholding taxes?

3.6 The debt/equity concepts apply to Division 11A of Part III of the ITAA 1936. This Division imposes a withholding tax on Australian sourced dividends, interest and royalties paid to non-residents. However, sections 128AE, 128F, 128J and 128K of the ITAA 1936 are specifically excluded from the application of the debt/equity concepts because relevant references in these sections relate to levels of ownership rather than the taxation treatment of a payment from the payers and recipients points of view. [Schedule 1, item 82, section 128AAA]

3.7 For the purpose of determining the boundary between interest and dividend withholding tax, interest (as defined in subsection 128A(1AB) of the ITAA 1936) includes an amount that is a dividend paid in respect of a non-equity share (see paragraph 2.16 for an explanation of what is a non-equity share as defined in subsection 6(1)) [Schedule 1, item 84, paragraph 128A(1AB)(d)] . For consistency, the definition of dividend does not include a dividend paid in respect of a non-equity share. [Schedule 1, item 83, paragraph 128A(1)(b)]. This ensures that interest withholding tax applies to these dividends, rather than dividend withholding tax.

3.8 A non-share dividend (generally a distribution or crediting of an amount in respect of a non-share equity interest) is now potentially subject to dividend withholding tax [Schedule 1, item 82, paragraph 128AAA(1)(c)] . Previously, such amounts may have been subject to interest (or less commonly, royalty) withholding tax. To the extent to which an amount is a return on an equity interest, neither interest nor royalty withholding tax will apply. [Schedule 1, item 84, subsection 128A(1AB); item 85, subsection 128B(2D)]

What is the effect of the debt/equity rules on the foreign dividend account system?

3.9 Division 11A, which applies to a non-share dividend in the same way as it applies to a dividend, also provides the rules for the operation of FDA [Schedule 1, item 82, paragraph 128AAA(1)(c)] . The practical effect of the debt/equity rules on the FDA system is in relation to the payment of dividends to non-residents out of the FDA. A return on an equity interest may be a dividend or a non-share dividend within the meaning of subsection 6(1) of the ITAA 1936 and this applies for FDA purposes where a resident company makes an FDA declaration in relation to a dividend or non-share dividend paid .

3.10 With regard to the receipt of a qualifying foreign source dividend by a resident company, although the expanded meaning of dividend applies, it is either the receipt of a non-portfolio dividend (within the meaning of section 317 of the ITAA 1936) or a dividend from a related company (within the meaning of subsection 51AE(16) of the ITAA 1936) that may result in a credit to the FDA. As the expanded meaning of dividend does not apply to a non-portfolio dividend, in practice the types of non-share dividends received by a resident company that may qualify for a FDA credit will only be non-share dividends paid to a resident company by a related company where a FDA debit arises for the paying company.

How do the debt/equity rules apply to the foreign tax credit system?

3.11 Division 18 of Part III of the ITAA 1936 provides a credit for foreign tax paid in respect of foreign income that is included in the assessable income of an Australian resident. The debt/equity rules apply to sections 160AE, 160AEA, 160AF, 160AFAA and 160AFD of the Division. The application of the debt/equity concepts is not extended to the remaining sections of the Division because relevant references in these sections relate to levels of ownership rather than the taxation treatment of a payment from the payers and recipients points of view. [Schedule 1, item 90, section 160ADB]

3.12 Currently, where an Australian company receives a non-portfolio dividend from a related foreign company it is allowed a foreign tax credit for foreign underlying tax paid on profits by the foreign company. A basic premise of this treatment is that the foreign tax is paid on the pool of profits from which the dividends are drawn and as a result the Australian company is paying tax on both. Therefore, this treatment ensures relief from double tax on non-portfolio dividends.

3.13 However, the credit will not be extended to non-share dividends. Typically non-share dividends have the legal form of interest payments and are deducted in calculating profits. An equity interest that distributes a non-share dividend does not necessarily carry the requisite voting rights for the companies to be related. This treatment is consistent with the exemption of certain non-portfolio dividends paid to a resident company, under section 23AJ of the ITAA 1936. The application of the debt/equity rules does not extend to the exemption provided in section 23AJ because whether a dividend qualifies for the section 23AJ exemption ultimately depends on whether the recipient and paying companies are related.

3.14 In ascertaining the baskets of foreign income, the debt/equity rules will determine the boundary between interest and dividend. The treatment of a non-share dividend will be the same as a dividend [Schedule 1, item 47, subsection 6AB(5B); item 48, subsection 6AC(7); item 90, paragraph 160ADB(1)(c); item 92, paragraph 160AE(4)(b)] . Interest will not include a return on an equity interest (which also impacts on the quarantining rules for foreign losses where interest income is a separate class of foreign income) [Schedule 1, item 91, paragraph 160AE(3)(da)] .

What effect will the debt/equity rules have on the accruals regime?

3.15 The accruals measures have been carved out from the application of the debt/equity rules as the proposed foreign source income review will address the implications of this and other measures. The review was foreshadowed in A Tax System Redesigned and on 22 March 2001, Treasurers Press Release No. 16 reiterated the Governments support.

3.16 Consistent with the intention of the carve out, this bill makes amendments which have the effect of ensuring that the accruals measures continue to operate as if the debt/equity rules were not implemented. This is achieved by ensuring that the debt/equity concepts contained in Division 974 do not apply for the purposes of:

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calculating the net income of a non-resident trust estate for the purposes of attribution where the trust is covered by Division 6 of the ITAA 1936 or the transferor trust provisions; and

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calculating the attributable income of an eligible CFC in Part X of the ITAA 1936, or in determining the foreign investment fund income by the calculation method in Part XI of the ITAA 1936.

3.17 However, Division 974 does not contain all the amendments giving effect to the debt/equity rules. Therefore, it is necessary to carve out the operation of provisions which are dependent on expressions implemented in Division 974 when applying the accruals measures. [Schedule 1, item 71, subsection 96C(5A); item 72, subsection 102AAW(2); item 111, section 389A; item 113, section 557A]

3.18 For example, one of the basic assumptions in the calculation of the attributable income of a CFC is that the CFC is treated as though it is a resident. Therefore, the operation of provisions such as subsection 44(1) of the ITAA 1936 is imported to calculate attributable income. Currently subsection 44(1) refers to dividends within the meaning of subsection 6(1), however, the debt/equity rules will amend subsection 44(1) to include non-share dividends in the assessable income of a resident shareholder. The intention of the carve out is that the operation of the amended provision be ignored to the extent that it depends on the debt/equity rules.

3.19 Another example of ensuring that the accruals measures continue to operate as if the debt/equity rules were not implemented is the retention of Division 3A of Part III of the ITAA 1936 . However, Division 3A will be limited to providing a definition of convertible note and to the calculation of attributable income of a CFC for the purposes of Part X of the ITAA 1936. [Schedule 1, item 67, section 82LA; item 112, section 398A]

3.20 This treatment for the accruals regime is also consistent with the exemption of certain amounts paid out of previously attributed CFC income (section 23AI of the ITAA 1936) and previously attributed FIF income (section 23AK of the ITAA 1936). The application of the debt/equity rules does not extend to these exemptions as they rely on terms defined as part of the CFC and FIF regimes, respectively.

Application of the new debt/equity rules to public trading trusts and corporate unit trusts

3.21 Certain unit trusts are taxed in an equivalent way to companies. These are public trading trusts and corporate unit trusts identified in Divisions 6B and 6C of Part III of the ITAA 1936.

3.22 The new debt/equity rules apply in relation to these trusts in an equivalent way to how they apply to companies. [Schedule 1, item 74, paragraph 102L(2)(c); items 75 and 77, paragraph 102T(2)(c); items 78 and 102, Division 7A of Part IIIA Subdivision CA]

Application of the new debt/equity rules to the proposed thin capitalisation regime?

3.23 The debt/equity rules apply in determining the extent to which deductions may be disallowed under the proposed thin capitalisation regime. Under the proposed regime it is necessary to determine the debt capital of an entity and the debt deductions in relation to that capital. An arrangement will constitute debt capital of an entity if it satisfies the debt test and it is on issue . The proposed thin capitalisation regime is discussed in the explanatory memorandum to the New Business Tax System (Thin Capitalisation) Bill 2001.

Consequential amendments

3.24 There are a number of consequential amendments arising from the new debt and equity rules. These are explained in paragraphs 3.25 to 3.45.

Amendments to provisions relating to the intercorporate dividend rebate

3.25 Under the current law, dividend on shares that are equivalent to interest on a loan do not provide an entitlement to the intercorporate dividend rebate under section 46D of the ITAA 1936. This is because such dividends are more appropriately characterised as returns on debt then as returns on equity. For the same reason dividends on shares which satisfy the debt test (non-equity shares) are not eligible for the intercoproate dividend rebate, whether received directly or indirectly through a trust or partnership. [Schedule 1, item 61, subsection 45Z(1A); item 62, subsection 46(1); item 63, subsection 46A(1)]

3.26 Similarly, no intercorporate dividend rebate is available for dividend-equivalent payments (unit trust dividends) by corporate unit trusts or public trading trusts taxed like companies if such payments are made in respect of units in the trust that satisfy the debt test. [Schedule 1, item 74, paragraph 102L(2)(c); item 77, paragraph 102T(2)(c)]

Amendments to the imputation provisions

3.27 Minor consequential amendments are made to the imputation provisions in Part IIIAA of the ITAA 1936 to ensure that non-share dividends are generally frankable and that dividends on shares satisfying the debt test (non-equity shares) are not. The consequential amendments also clarify that non-equity shares will constitute finance shares for the purposes of Part IIIAA and that dividends on them will not be frankable. [Schedule 1, items 94, 96, 99 and 100]

Amendments to the capital gains provisions

3.28 Certain provisions relating to capital gains and losses will be amended as a consequence of the new debt/equity rules. These relate to:

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cost base rules for convertible notes and certain rights; and

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exclusions from CGT events D1 (about creating contractual or other rights) and H2 (about receipts for an event relating to a CGT asset).

3.29 Amendments to be included in a later bill will include those to other CGT provisions, if any, that are identified as being necessary as a consequence of the new debt/equity rules.

Exclusions from CGT events D1 and H2

3.30 Presently, borrowings and the issue or allotment of shares are expressly excluded from CGT events D1 and H2 where they might otherwise result in the proceeds being, inappropriately, subject to CGT. Similarly, the grant of an option to acquire shares or debentures is excluded from these CGT events.

3.31 To prevent the inappropriate application of CGT, the creation of non-share equity interests, and the granting of options to acquire such interests, are to be brought within the scope of these exclusions. This will be achieved by referring to the broader concept of equity interests rather than shares in the relevant provisions. [Schedule 1, items 7 to 10]

3.32 Shares that are acquired other than as a result of a CGT event (i.e. because the holder subscribed to the issue of the shares) are acquired at the earlier of when the shares are issued or allotted, or when a contract to do so is entered into.

3.33 The same rule will apply to the acquisition of non-share equity interests. This will be achieved by referring to the broader concept of equity interests rather than shares in the relevant provisions. [Schedule 1, item 11, section 109-10, item 2 in the table]

3.34 These amendments to the CGT event and acquisition provisions will apply to equity interests issued or allotted on or after 1 July 2001, and to options to acquire such interests granted on or after that date. [Schedule 1, subitem 118(3)]

Convertible notes and certain rights

3.35 The definition of convertible note in section 82L of the ITAA 1936 is being replaced, except for the purposes of calculating the attributable income of a CFC, by the concept of convertible interest. Therefore, the CGT rules that provide cost base calculations for shares acquired as a result of converting a convertible note or exercise of an option need to be consistent with the new terminology. [Schedule 1, items 5, 6 and 12 to 17; Schedule 2, item 5, definition of convertible interest in subsection 995-1(1)]

3.36 In addition, certain options that fall within the current section 82L definition of convertible note may not be a convertible interest according to the new concept. For example, a company that issues an option, that is within the section 82L meaning, allowing the holder to have shares issued to them on its exercise may not be the company who issues shares to the option holder. That is, another company may actually issue those shares to the taxpayer. If that other company is unrelated to the company that issued the option then the option will fall outside the definition of a convertible interest. As a result the exercise of certain options may now fall within Subdivision 130-B (dealing with shares etc acquired on exercise of an option) and no longer in Subdivision 130-C (dealing with shares and etc acquired on conversion of a convertible interest). Therefore, consequential amendments are made to both Subdivisions 130-B and 130-C of Part 3-1 of the ITAA 1997.

3.37 The consequential amendments will replace the existing cost base and reduced cost base calculations with a standard calculation. The following comments on the amendments to those Subdivisions apply equally to both the cost base and reduced cost base of an asset acquired on exercise of an option or conversion of an interest. [Schedule 1, items 18 to 32]

3.38 For options or convertible interests that fall within Subdivisions 130-B and 130-C, the first element of the cost base (acquisition cost) of the shares acquired on exercise of the option or conversion of the interest will be equal to the cost base of the option or convertible interest. This acquisition cost will be increased with amounts that have reduced a capital gain the taxpayer has made from either the exercise or conversion. This is so even though the capital gain is disregarded under those Subdivisions. This is achieved by providing a direct link to section 118-20 of the ITAA 1997. This section avoids double taxation, as a capital gain made from a CGT event is reduced under this section to take account of any other provisions that include an amount in assessable or exempt income.

3.39 Subdivisions 130-B and 130-C do not require a capital gain to be realised on exercise of a right or conversion of a convertible interest, deferring the realisation of a capital gain to the final disposal of the share. Because of this, section 118-20 is unable to reach back to the right or convertible interest before it was converted into a share. This is because section 118-20, in working out the capital gain to be realised on sale of the share, only takes account of any other provision that includes an amount in assessable or exempt income because of the CGT event happening to the share, and not because of the right or convertible interest. Therefore, specific links are needed within those Subdivisions to section 118-20 to take into account amounts included in assessable income or exempt income because of a CGT event happening to the right or convertible interest. This avoids double taxation on that final disposal of the share.

Example 3.1: Cost base of a share acquired on conversion of a convertible interest.

A taxpayer in year 1 acquires on issue a convertible interest for $84, which has a face value of $100. The interest is acquired on 1 July 2000. The interest is a qualifying security subject to Division 16E of the ITAA 1936.

The convertible interest has a term of 5 years. In each of those years the taxpayer will receive $5 interest income.

As the taxpayer acquired the interest at a $16 discount ($100 face value for a purchase price of $84), subsection 159GQ(2) of the ITAA 1936 would include $1.98 in year 1 and $3.09 in year 2 in the taxpayers assessable income as an accrued gain.

At the beginning of year 3, the taxpayer converts the interest into a share with a market value of $110.

Section 159GS of the ITAA 1936 will include in the taxpayers assessable income a net profit on the interest of $19.93. This is calculated as $110 less $84 (cost) and $1.98 and $3.09 accrued gain already included in the taxpayers assessable income under subsection 159GQ(2).

The amendments to Subdivisions 130-B and 130-C will avoid double taxation occurring on the eventual sale of the share by working out the first element of the cost base of the share as a sum of the cost base of the convertible interest at the time of conversion and any amount that has reduced a capital gain made on the convertible interest.

The conversion of the interest leads to the taxpayer making a capital gain (even though the capital gain is disregarded). Subsection 118-20(1) of the ITAA 1997 reduces that capital gain by the section 159GS amount being the $19.93 net profit.

Subsection 118-20(1A) of the ITAA 1997 will also reduce the capital gain by the subsection 159GQ(2) amounts being the $6.07 accrued annual gain.

As a result, the first element of the cost base of the share would be $110. This being the sum of the $84 purchase price of the convertible interest (assuming this is the cost base of the interest at the time of conversion) plus the $19.93 net profit and $6.07 of accrued annual gain.

The $5 interest the taxpayer received annually on the convertible interest does not form part of the cost base of the share. This is because section 118-20 does not reduce the capital gain by those amounts.

If the taxpayer then sells the share for $120, the taxpayer will have a capital gain of $10, being the difference between the cost base (assuming it is still $110) and the capital proceeds of $120. This is the correct outcome.

In the absence of a link to section 118-20 of the ITAA 1997 in Subdivisions 130-B and 130-C of that Act, the taxpayer would have a first element of the cost base of only $84, being the purchase price of the convertible interest assuming the taxpayer did not pay anything for conversion. If the taxpayer sells the share for $120, the taxpayer would have a capital gain of $36.

The taxpayer would be assessed twice on an amount of $26 due to $19.93 of the $36 capital gain already having been included in their assessable income under section 159GS of the ITAA 1997 and another $6.07 of accrued gain under subsection 159GQ(2).

Amounts deducted

3.40 By referencing the first element of the cost base of the share to the cost base of the right or convertible interest at the time of its exercise or conversion, an amount in respect of the cost base that is deductible to the taxpayer would reduce that cost base before it is incorporated into the first element of the cost base of the share. Division 110 of the ITAA 1997 determines which amounts do not form part of a cost base or reduce that cost base. [Schedule 1, items 21 and 27]

Application provisions for capital gains amendments

3.41 There is an application provision for rights issued to a taxpayer because they own a convertible note that was acquired before 20 September 1985. The application provision provides consistent treatment for such a right that is exercised under Subdivision 130-B as that for a right issued to a taxpayer because the taxpayer owned a convertible interest that was acquired before 20 September 1985. [Schedule 1, subitem 118(5)]

3.42 The amendments to Subdivision 130-B and 130-C will apply to the exercise of a right or conversion of a convertible interest after 30 June 2001. [Schedule 1, subitem 118(4)]

Miscellaneous consequential amendments

3.43 The new debt/equity rules supersede the debt dividend provision in section 46D of the ITAA 1936. Section 46D is therefore repealed. [Schedule 1, item 64]

3.44 This provision continues to operate, however, in relation to interests for which an election described in paragraph 2.211 is made. [Schedule 1, subitem 118(6)]

3.45 The convertible note provisions in Division 3A of Part III of the ITAA 1936 do not apply to returns paid on or after 1 July 2001 unless an election is made for the current law to continue to apply in relation to particular interests (see paragraph 2.211). However, the provisions continue to have a residual operation for the purposes of calculating an eligible CFCs attributable income for the purposes of Part X of the ITAA 1936 and for providing a definition of convertible note. [Schedule 1, items 67 to 69, section 82LA and subsection 82L(1)]