House of Representatives

Explanatory Memorandum

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

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.