House of Representatives

Explanatory Memorandum

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

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:

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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:

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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

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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:

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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

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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:

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deductible interest expense - 12.75 per cent per annum; and

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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:

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

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

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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:

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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

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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:

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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);

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

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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

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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:

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

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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:

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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

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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:

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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.

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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.

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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:

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a repayment of the principal borrowed; or

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any of the following:

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an application fee;

•

a brokerage commission;

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

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a charge imposed by an approved stock exchange;

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a fee to extend or vary the borrowing; or

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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 ]