Co-written by John Wells
An overview of the rules for determining whether a membership interest in a company or an interest in a financing arrangement is a debt or equity interest for income tax purposes
The income tax law (‘Law’) provides different taxation outcomes for returns paid to Australian resident shareholders (‘shareholders’) and for returns paid to Australian residents who hold debt interests in entities (‘creditors’).
Returns paid to shareholders are taxed in the hands of those shareholders as dividends at a rate determined by each shareholder’s marginal tax rate. This rate of taxation may be reduced, however, if the shareholders can access franking rebates or credits in relation to those dividends.
Returns on investments paid to creditors, on the other hand, are considered payments in the nature of interest in the hands of those creditors. Such returns are taxed at each creditor’s marginal tax rate, but do not carry entitlements to franking rebates and credits. As a result, and unlike a dividend paid to shareholders with a franking rebate or credit attached, the whole amount of the return is subject to income tax.
The Law also has different taxation outcomes for capital raising entities in terms of income tax deductibility for returns paid or payable by such entities to shareholders and creditors.
Companies paying dividends to shareholders are not able to claim income tax deductions in respect of such payments, however entities paying returns to creditors may be entitled to claim income tax deductions for these payments.
As a result of these different taxation outcomes, entities seeking to raise capital have had a real incentive to customise their capital raising arrangements to take into account the opportunities presented by the Law and their respective taxation profiles, to lower the cost of their capital. Often this has been achieved by the use of hybrid financial products which incorporate features of both traditional debt and equity arrangements. These opportunities have been available largely because the Law, as it existed before 1 July 2001, substantially characterised an interest in a capital raising arrangement as equity or debt according to its legal form without much regard to the economic substance of the underlying arrangement.
The Commonwealth Government (‘Government’) has now moved to address this arbitrage opportunity and also to provide clearer guidelines on what is equity and debt for income tax purposes.
CHANGES TO THE LAW
From 1 July 2001, the New Business Tax System (Debt and Equity) Act 2001 (‘Act’) operates to define, for most income tax purposes, what constitutes equity in a company and what constitutes debt. The Act sets out a number of tests and specifically directs that the economic substance of a capital raising arrangement, in addition to its legal form, must be taken into account when characterising an interest as debt or equity.
IDENTIFYING THE SCHEME
The Act operates in respect of capital raising arrangements called schemes. A scheme is defined in the Act as:
- any agreement, arrangement, understanding, promise or undertaking; and
- any scheme, plan, proposal, action, course of action or course of conduct.
Further, a scheme may consist of a single scheme or a number of related schemes. Where there are a number of related schemes in existence, those related schemes are deemed to be one notional scheme for the purposes of the Act.
An example of a scheme consisting of a single scheme would be a simple arrangement for an issue of shares in a company. By contrast, an example of a notional scheme consisting of related schemes would be an arrangement involving an issue of shares in a company and a parallel arrangement containing a guarantee of payment of dividends on those shares.
It is critical to any application of the tests in the Act that the full extent of the scheme be identified. Failure to do so could lead to the tests being misapplied, and this could expose the parties to the scheme to penalties and general interest charges under the Law, and in the case of Australian resident investors, a denial of franking rebates and credits in respect of the returns on their interests in the scheme.
The Act defines the expression ‘related schemes’ and this definition always needs to be borne in mind when applying the Act. It states that two schemes are related to each other if:
- they are based on stapled instruments; or
- one of the schemes would, from a commercial point of view, be unlikely to be entered into unless the other scheme was entered into; or
- one of the schemes depends for effect on the operation of the other scheme; or
- one scheme complements or supplements the other; or
- there is another scheme to which both the schemes are related because at least one of the relationship scenarios set out above is met.
- It should be noted, however, that a scheme will not be related to another merely because it refers to the other or they have a common party.
With the exception of a scheme involving an issue of shares, the Act only applies to schemes that are financing arrangements.
A financing arrangement is a scheme entered into or undertaken to raise finance, to fund another financing arrangement or to fund a return payable under another financing arrangement.
The Act expressly excludes a number of schemes from being financing arrangements. The excluded schemes are:
- schemes for the payment of royalties nominated in section 974-130(4) of the Income Tax Assessment Act 1997 (‘ITAA 1997’);
- life insurance or general insurance contracts issued in the ordinary course of business of the issuer.
- selected arrangements involving the lease or bailment of property nominated in section 974-130(4) of the ITAA 1997.
- securities lending arrangements covered by section 26BC of the Income Tax Assessment Act 1936.
Derivatives used solely for managing financial risk and contracts for personal services entered into in the ordinary course of a business are generally also not considered to be financing arrangements for the purposes of the Act.
Under the Act, ‘equity interests’ in a company will be those that meet the equity test but which also do not meet the debt test. Broadly speaking, the interests mentioned in the Act as meeting the equity test are:
- interests providing terms that are contingent on economic performance or at the discretion of the company; and
- interests that may or will convert into such contingent interests or shares and.
- an issued interest that gives the holder or a connected entity of the holder a right to be issued with an equity interest in the company or an entity connected to the company.
Interests created under a financing arrangement or through an issue of shares will be debt interests in an entity where they meet the debt test in the Act.
The Explanatory Memorandum which accompanied the introduction of the New Business Tax System (Debt and Equity) Bill 2001 into the Commonwealth Parliament states that:
'An interest in a company is a debt interest (i.e. satisfies the debt test) if, at the time of its issue, there is a scheme that is a financing arrangement under which the company has an effectively non-contingent obligation to pay an amount (or the total of several amounts) to the holder of the interest at least equal to its issue price.'
This principle is embodied in the five elements of the debt test, which are:
- the scheme must be a financing arrangement, except where it involves an issue of shares;
- there must be a financial benefit received by the entity issuing the interests in the scheme (‘issuing entity’);
- the issuing entity must have an effectively non-contingent obligation to provide a future financial benefit to entities investing in the scheme; and
- it must be substantially more likely than not that the value of the financial benefit to be provided by the issuing entity will be at least equal to or exceed, the financial benefit received by it under the scheme.
To ensure the debt test does not operate inappropriately, a further element requires that, at least one of the financial benefits received and provided by the issuing entity not be nil.
A financial benefit will be received or provided for the purposes of applying the debt test whenever anything of economic value is received or provided.
Where an interest meets both the equity and debt tests in the Act, a ‘tie-breaker’ rule states that the interest should be classified as debt.
WHAT INTERESTS ARE effected AFFECTED?
The Act applies to all interests created under financing arrangements or issues of shares entered into or undertaken on or after 1 July 2001.
Issuers of interests under financing arrangements entered into before 1 July 2001 and issuers of shares issued before 1 July 2001 are generally granted a right to have the characterisation of those interests dealt with under the former taxation régime until 1 July 2004. This right, however, is lost if such an existing arrangement or share issue has its terms altered on or after 1 July 2001, is rolled over on or after that date or its original term is extended on or after that date.
Issuers of interests under financing arrangements entered into before 1 July 2001 and issuers of shares issued before 1 July 2001 can, nevertheless, opt to have the Act apply to their capital raising scheme immediately. To do this, they have to make a written election to this effect and lodge it with the ATO. Whilst this election is was required to be lodged with the ATO by 31 December 2001, the ATO has power to allow further time for the lodgment of such elections.
Whilst obviously the impact of the Act will always need to be considered in any new capital raising venture, its impact will also need to be considered where there is an alteration to, a rollover of, or an extension to the term of, an existing financing arrangement or share issue.
Furthermore, the broadness in definition of concepts used in the Act such as ‘scheme’, ‘financing arrangement’ and ‘financial benefit’ means that the Act has a much wider impact than one would normally expect.
In its quest to protect its revenue base, the Government’s introduction of the Act seems to have gone a long way towards removing the ‘mask’ from many hybrid capital raising arrangements by focusing on the economic substance of those arrangements. As always, however, the devil is in the detail and it remains to be seen whether the Act will achieve its stated objectives.
In this regard, it worth noting that the Act confers powers on the Commissioner of Taxation to expand the operation of the Act by conferring extensive powers on him to make regulations to augment the current tests and concepts set out in the Act.
Article as published in the March 2002 edition of ‘Taxation in Australia’
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.