SENATE

Explanatory Memorandum

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

Chapter 8 Infrastructure Borrowings - amendment of the Development Allowance Authority Act 1992

Overview

8.1 The amendments in Schedule 3 of the Bill will amend the Development Allowance Authority Act 1992 (the DAA Act).

Summary of the amendments

Purpose of the amendments

8.2 The objective of these amendments to Chapter 3 of the DAA Act is to prevent certain types of schemes undermining the integrity of the infrastructure borrowings program by breaking the symmetry in the special tax treatments of the payer and receiver of interest. Such schemes enable indirect infrastructure borrowings to be made functionally independent of the financing of an infrastructure project thereby increasing the value of tax benefits to those involved and the cost to revenue without a commensurate increase in the funding for private sector projects. To this end, the amendments will require:

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new indirect infrastructure borrowings or refinancing infrastructure borrowings that succeed them to be made only by Australian resident taxpayers; and

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any transfer of rights by a direct infrastructure borrowing lender or repayment of a direct infrastructure borrowing to be accompanied by repayment or parallel transfer of any associated indirect infrastructure borrowing or refinancing infrastructure borrowing that has succeeded the indirect infrastructure borrowing.

Date of effect

8.3 These amendments will apply from 30 October 1995.

Background to the legislation

General

8.4 Taxpayers who borrow funds to finance construction projects may not be able to utilise tax deductions for their interest costs in the early years of a project because the project produces no profits in those years and the taxpayer has no other source of income to absorb the deductions.

8.5 To encourage private investment in the construction of certain public infrastructure projects, legislation was enacted to allow companies borrowing to finance the construction of infrastructure projects effectively to transfer the interest deduction incurred on those borrowings to the providers of the finance.

8.6 This is achieved by the borrower foregoing deductions for the interest expense and the lender being exempt from tax in respect of the corresponding interest income (hereinafter to be read as entitling the lender to elect instead for a rebate of tax at the corporate rate, currently 36 per cent).

8.7 The double tax benefit of exempt interest/deductible interest expense is only available once in relation to each infrastructure borrowing. For example, if a bank raises funds from the public via an infrastructure bond issue and on lends the funds directly to an infrastructure developer, the individual infrastructure bond investors are entitled to the double benefit. In such a case the bank is treated as a mere conduit between the investors and the infrastructure developer, so that while its interest receipts from the developer are tax exempt its interest payments are not deductible: it is simply a vehicle for getting investors funds to the developer.

8.8 This policy is embodied in Chapter 3 of the DAA Act and Division 16L of the Income Tax Assessment Act 1936 (ITAA). The Development Allowance Authority and the Australian Taxation Office separately administer those acts and therefore jointly administer the infrastructure borrowings tax concession.

8.9 The DAA Act lays down the administrative requirements which must be satisfied before an infrastructure borrowings certificate may be granted. Concessional tax treatment becomes available when a certificate is issued. The requirements list the criteria for a borrower.

8.10 There are three kinds of infrastructure borrowing. These comprise:

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direct infrastructure borrowing (DIB)( section 93F of the DAA Act);

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indirect infrastructure borrowing (IIB)(section 93G); and

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refinancing infrastructure borrowing (RIB)(section 93H).

8.11 Each of the borrowings is required to meet the borrower requirements set out in section 93I of the DAA Act. The basic requirements are listed in subsection 93I(2).

8.12 A DIB certificate holder needs also to comply with a spending requirement (section 93J of the DAA Act) and an intention to use requirement (section 93K of the DAA Act).

8.13 There are seven eligible types of infrastructure: a land transport facility, air transport facility, seaport facility, electricity generating, transmission or distribution facility, gas pipeline facility, water supply facility, sewage or wastewater facility. (Section 93L of the DAA Act)

8.14 The special tax treatment for infrastructure borrowings is available for a maximum period of 15 years. (Section159GZZZZD of the ITAA)

8.15 Once an infrastructure borrowing has been certified by the Development Allowance Authority, the tax effects of the borrowings on borrowers and investors are:

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interest derived under infrastructure borrowings is not assessable to investors;

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interest paid on infrastructure borrowings is not an allowable deduction to borrowers;

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any profit of a trading, revenue or capital nature derived on disposal or redemption of any debt instrument that constitutes an infrastructure borrowing is tax exempt;

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any loss of a trading, revenue or capital nature incurred on the disposal or redemption of any debt instrument that constitutes an infrastructure borrowing is not tax deductible.

Schemes to establish a free standing indirect borrowing

8.16 In late 1995, the Development Allowance Authority, the Australian Taxation Office, and Treasury became aware of attempts to market schemes which clearly contravened the intention of the infrastructure borrowings concession by seeking to obtain a multiplication of the infrastructure tax benefits.

8.17 On 30 October 1995, the previous Government issued a press release stating it would move against those sorts of schemes, ie those schemes which ...have the effect that indirect infrastructure borrowings can be made functionally independent of the financing of an infrastructure project. A 'free-standing' indirect borrowing would lack any justification for the special tax treatment which applies to it. The schemes also have the effect that the symmetry in the special tax treatments of the payer and receiver of interest, which is needed in order to limit the cost to revenue of infrastructure borrowings, is broken.

8.18 The Government has endorsed this decision in the

1996-97 Budget with the objective of preventing those sorts of schemes from undermining the integrity of the program. Statement 4 in Budget Paper No.1 reported: If allowed to proceed, such schemes would substantially increase the value of tax benefits to those involved, and the cost to revenue, without a commensurate increase in the funding for private sector infrastructure projects.

8.19 The arrangements outlined in the press release of 30 October 1995 are based on the quite straightforward idea that a bank or other financier, which holds an IIB and is the conduit through which infrastructure borrowings are passed on to the infrastructure developer, can assign its interest as the eligible direct infrastructure lender to another entity. In simple terms, the original direct lender sells out its direct lending interest to another entity whilst retaining the IIB.

8.20 When that is done, the new entity obtains status as a direct infrastructure lender. It is eligible for the double benefit of tax exemption on interest received from the developer and tax deductibility for interest paid on borrowings raised to fund the assignment. The result, in summary, is that there are two unrelated groups of lenders in the exempt interest/deductible interest category for the one set of interest payments that are non-deductible to the project developer.

Schemes involving overseas entities

8.21 In some cases the intermediary which holds an IIB certificate is not an Australian resident and does not have a permanent establishment in Australia. In these cases:

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exempt interest paid to the intermediary or payments for the assignment of the direct borrowing rights are free of withholding tax in Australia; and

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exempt interest paid by the intermediary to the Australian lenders is fully deductible in the country where the intermediary is taxed.

Explanation of the amendments

Indirect infrastructure borrowings restricted to resident taxpayers

8.22 By inserting in subsection 93D(1) definitions of non-exempt resident company [item 2] , non-exempt resident corporate limited partnership [item 3] , relevant exempting provision [item 4] and resident [item 5] effect is given to the Government's decison that only Australian resident taxpayers can be indirect infrastructure borrowing certificate holders. Because of the interrelationship between the DAA Act and the ITAA, the definition of "resident" is adopted from the ITAA. A minor alteration is made to the definition of Crown lease [item 1] .

8.23 New subsections 93I(4A), 93I(4B) and 93I(4C) require that an eligible borrower of either an IIB or a refinancing infrastructure borrowing that succeeds an IIB must be either a non-exempt resident company at the time of the borrowing or a non-exempt resident corporate limited partnership in relation to the year of income in which the borrowing is made. Neither type of borrower can be acting in the capacity of trustee.

8.24 While holding an indirect infrastructure borrowing certificate (or a refinancing borrowing that has succeeded an indirect borrowing), the holder must remain an Australian resident taxpayer at all times. [Item 6]

8.25 If the certificate holder's taxpaying residency status changes while the indirect infrastructure borrowings (IIBs) is on foot, the Development Allowance Authority is taken to have cancelled the certificate with effect from the time of cessation of residency. [Item 7 - new section 93ZAA]

8.26 The DAA Act currently provides for grounds for cancellation of an infrastructure borrowing certificate. Proposed new subsection 93ZAA(3) deems cessation of residency to be an additional ground for cancellation of the certificate.

Transfer of rights or repayment of a DIB

8.27 These amendments give effect to the Governments decision that any transfer of rights or repayment under a DIB must be accompanied by a repayment or parallel transfer of any associated IIB or RIB that has succeeded the IIB. This is intended to prevent the situation arising where IIBs are functionally independent of the financing of an infrastructure project eg. because previously related direct borrowing rights have been assigned by the direct lender to another person or have been paid out.

Transfer of rights under a DIB

8.28 Whenever a direct infrastructure lender transfers any of its rights under the direct lending instrument to another party, it will be required to either repay a related IIB or transfer the IIB certificate and all its obligations to the transferee of the rights under the direct borrowing. Failure to do this within 30 days will cause the IIB certificate to be taken to have been cancelled by the DAA from the date of the transfer. [Item 7 - new section 93ZAB] The transfer of any or all of the rights, interests and obligations under the IIB is deemed, in these circumstances to be an additional ground for cancellation of certificates by the DAA.

8.29 A direct infrastructure lender must repay all amounts owing on related IIBs if it transfers to another entity all its rights under the direct lending contract. If it does not do so, cancellation of the IIB certificate may be avoided by transferring to the same transferee all remaining rights and obligations under the related IIB contract, with a consequent transfer of the IIB certificate to that transferee under section 93V of the DAA Act. [Subparagraph 93ZAB(1)(c)(i)]

8.30 If a direct infrastructure lender transfers to another entity only some of its rights under the direct lending contract, eg. by assigning its rights to receive repayments of principal or interest, it would be required to repay all amounts owing on related IIBs. [Subparagraph 93ZAB(1)(c)(ii)]

Repayment of a DIB

8.31 If the whole of a DIB is repaid, the direct lender is to be required to repay the whole of a related IIB unless the repayment of the DIB was financed by a RIB. In this case, the IIB certificate holder can either repay the IIB or pass the certificate transfer test . This test requires that an application be made to the DAA for the IIB certificate to be transferred to the refinancing infrastructure borrower and the DAA has transferred or is required to transfer the certificate. Failure to do this within 30 days will cause the IIB certificate to be taken to have been cancelled by the DAA from the date of the payment. The repayment of the DIB is an additional ground for certificate cancellation by the DAA. [Item 7 - new section 93ZAC]

8.32 In a case where only a part of a DIB is repaid, the direct lender will be given the opportunity to reduce, in a similar proportion, the amount owing on a related IIB. Failure to do this within 30 days will cause the IIB certificate to be taken to have been cancelled by the DAA from the date of the payment. An indirect infrastructure borrower may repay a greater proportion of the IIB within the 30 days. [Item 7 - new section 93ZAD]

Consequential amendments

8.33 Subsection 93ZB(3) is amended so that if an IIB certificate is taken to have been cancelled a related RIB certificate is also taken to have been cancelled at the same time and for the same grounds as the IIB. [Items 8 and 9]

Application of amendments

8.34 These amendments apply where a certificate in respect of an IIB or a RIB that succeeded an IIB was issued on or after 30 October 1995. [Item 10]