The Taxation Institute of Australia. Review of the debt/equity provisions of the income tax law regarding certain at call loans

Transcription

1 Submission by The Taxation Institute of Australia In response to the Treasury Discussion Paper Review of the debt/equity provisions of the income tax law regarding certain at call loans April 2004

2 Set out below is the Taxation Institute s submission in response to the Treasury Discussion Paper, Review of the Debt/Equity Provisions of the Income Tax Law Regarding Certain At Call Loans (the Discussion Paper). The Taxation Institute makes some general comments about its overall position on this Discussion Paper, followed by specific comments, which address each section of this Paper. GENERAL COMMENTS The Debt/Equity Rules and at call loans As a matter of law and economic reality, for reasons indicated below in relation to Section 1 of the Discussion Paper, the Taxation Institute is of the view that there are few if any circumstances in which at call loans qualify as an equity interest. Division 974 should have no application to at call loans generally. Impact on the Small and Medium Enterprise (SME) Sector In the event that it is proposed that Division 974 should apply to at call loans, this should be made clear by the legislation. Further, convincing policy reasons should be provided. In any event, the Taxation Institute seriously questions whether the SME sector should be subject at all to the debt/equity regime in the manner contemplated in the Discussion Paper. Businesses operating in the SME sector have recurring debt funding needs. This type of funding is almost without exception genuine debt funding, to the extent that the party providing the funds has the expectation that the amount lent will be repaid, be it at interest or interest-free. These loan funds may be provided frequently, at short notice and as the business need arises. SME businesses regularly need their owners, or business associates who have money available, to make loans to them in order for their business to be carried on. In this environment, it is not reasonable to expect SMEs to be accustomed to the level of sophistication needed to delineate between different types of funding interests in a manner that is contemplated by the debt/equity rules. Furthermore, SMEs should not be expected to deal with a regime which requires every contribution to the debt and equity capital make-up of the company (be it for a short or long term) to be classified in accordance with these rules. Accordingly, the Taxation Institute recommends a significant de minimis threshold in the existing debt/equity rules to prevent their application to the SME sector. This type of de minimis rule would also be consistent with the need to reduce red tape for SMEs. Non-resident lenders The Taxation Institute understands that Treasury may be concerned to address problems that may arise where the lender is a non-resident. Generally, where the borrower and the lender are on-shore, whether interest is paid or not, tends to have a tax neutral outcome. When the lender is off-shore, the payment of interest can potentially create an Australian mismatch because there is a deduction available in Australia and only withholding tax is payable upon the payment of interest. However, the thin capitalisation provisions are expressly introduced to deal with this issue and the pure debt equity provisions should not be used as a further form of systemic sanction. Page 1

3 SPECIFIC COMMENTS INTRODUCTION At call loans made before 1 July 2004 Subject to our comments below in relation to Section 1 of the Discussion Paper, the Discussion Paper "looks at at call loans made after 30 June 2004" 1. However, this overlooks the important and additional issue of at call loans made before 1 July 2004, which may become "equity" on or after that date. In order to ensure that these pre-1 July 2004 loans do not become equity, it will be necessary to ensure that they are debt. This will typically require affected entities to have appropriate loan agreements in place with all connected entity lenders. Pragmatically, these loan agreements will need to be in place prior to a loan being made in order to ensure that there is not a subsequent restructuring of such a loan, which could potentially come within Section 45B of the Income Tax Assessment Act 1936 (ITAA 1936). Therefore, the status of pre-1 July 2004 at call loans needs to be considered in the context of the current Discussion Paper. Timing It is noted in the Introduction that the transitional provision in relation to at call loans is to cease to have effect on 1 July The reasons expressed in the Explanatory Memorandum were, broadly, to ensure that industry had "sufficient opportunity to review and organise such arrangements so that they fall on the particular entity's preferred side of the debt/equity border". We note that the transitional provisions appear to have been included by way of an abundance of caution and do not have the effect that at call loans are to be treated as equity. The Taxation Institute is strongly of the view that industry does not have sufficient opportunity to review and organise arrangements addressed in the Discussion Paper in accordance with Division 974 on or by 30 June Almost 17 months have passed since the Assistant Treasurer's announcement and consultation has commenced less than three months before the sunset date of the transitional provisions. Accordingly, the Taxation Institute recommends that the transitional provision in relation to at call loans be extended by 12 months (to expire on 30 June 2005) to allow full and proper consultation. 1 Page 1 of the Discussion Paper Page 2

4 SECTION 1: In what circumstances may an at call loan qualify as an equity interest? It is submitted that as a matter of law and economic reality a loan repayable on demand, or on reasonable notice, is the very antithesis of equity. A loan repayable on demand is just that; the lender, whether related or not, is entitled to payment upon having given reasonable time to meet the demand 2 and will rank equally with other, usually unsecured, creditors. Loans repayable on demand are common. In fact most bank loans are repayable on demand with interest payable at such rate as the bank advises from time to time. The statement that at call loans can be used to flexibly augment the capital of the company without increasing its liabilities to third parties 3 is a non-sequitur. A loan, whoever from, will never create a liability to a person to other than the lender and will always result in a liability to the lender. Furthermore, it is incorrect to say that at call loans may also enable the company to effectively reduce its capital without having to meet the formal requirements of the Corporations Act. Every loan can be repaid without having to meet the requirements of s 265B of the Corporations Act. That is because the Corporations Act draws a clear distinction between share capital and loans resulting in a creditor-debtor relationship. Section 265B of the Corporations Act is expressly concerned with the former and not the latter. Taxation laws should avoid drawing distinctions which are contrary to the general law. Such distinctions can only add further complexity to an already complex system. The reason one can repay at call loans without meeting the formal requirements of the Corporations Act is because, for corporation law purposes, these loans are not treated as equity! Tax law should be slow to treat them differently unless good reason can be demonstrated. So-named at call loans frequently arise between related parties because they choose not to document the terms on which loans are made or choose not to specify terms. In such a case the law implies, subject to agreement to the contrary, that the loan is interest free and repayable on reasonable notice. Any obligation to pay interest can only arise by agreement between the parties. The reason loans between related parties are often left undocumented is because each party is usually controlled by the same people and any agreed terms could be changed quite readily. The suggested requirement to document loans between related parties is unnecessary as whatever the written terms they can be varied instantaneously. The commercial advantage of at call loans is that they provide loan capital in circumstances where the lender will rank with other unsecured creditors. There is no particular advantage in having the loan undocumented save that to document loans where the creditor and debtor are controlled by the same people would often be of no practical significance and add unnecessary expense. It is simply incorrect to say that the terms of such a loan are flexible. The terms are that the loan is interest free and repayable on demand unless there is an agreement to the contrary. The Treasury Paper suggests that an at call loan may satisfy the equity test in item 3 of the schedule to s (1) of the 1997 Act. This provides: 2 3 See Bunbury Foods Pty Ltd v National Bank of Australasia Ltd (1984) 153 CLR 491 at Page 4 of the Discussion Paper. Page 3

5 3. An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of: (a) (b) the company; or a connected entity of the company. The return may be a return of an amount invested in the interest. It is difficult to see how a loan where the only right is to have the loan repaid on demand would satisfy this test. It is simply incorrect to say that a right to demand repayment of the debt upon giving reasonable notice is a right to a variable or fixed return which is discretionary. Further, it is also incorrect to say that the ability of the debtor and creditor to agree on the interest rate gives rise to a return which is at the discretion of one party. A right to interest on a loan can only arise by agreement. Neither a lender nor a borrower can unilaterally demand or determine what interest is payable. A loan could only satisfy item 3 if it was an express term of the loan that interest would be payable at such a rate as is determined in the discretion of the company or a connected entity. Such a loan would be most unusual and would not be one the law would imply in the case of a loan where no terms had been agreed. While a lender may be a connected entity of the company it is clear that the intention of item 3 is to catch as equity interests cases where the borrower or a related party, as opposed to the lender, can unilaterally determine the return. This cannot be done in the case of normal at call loans. Further, it is also incorrect to say in the case of a loan repayable on demand that the liability is contingent. It may be that the debt is not enforceable until reasonable demand has been given but in no sense is that a contingent liability. Page 4

6 SECTION 2: Impact of equity tax treatment for specified at call loans In looking at the impact of treating specified at call loans as equity, Treasury needs to be mindful of our view about the inapplicability of Division 974 to at call loans in general: see our response to Section 1 of the Paper. Treasury should also be aware of our view that there needs to be a carve out in Division 974 for the SME sector. That said, it is noted that the Discussion Paper seeks information on the extent to which specified at call loans are used by small business companies and the extent to which they are interest free. The Taxation Institute is not in a position to provide empirical evidence on the use of specified at call loans. However, one possible avenue to assist in calculating the number of affected taxpayers would be by, broadly, identifying from relevant statistics the number of companies that lodge tax returns. Even where there is a consolidated group, it is entirely possible that loans have been made to subsidiaries by connected entities that are not members of the consolidated group. The outcome is likely to be a significant number. Maintaining a non-share capital account As the Taxation Institute is of the view that Division 974 should not apply to at call loans, it follows that there should be no need to maintain a non-share capital account as these loans should not be classified as an equity interest for the purposes of both Division 974 and this account. If it is decided as a matter of policy that at call loans should be treated as equity, it is noted that comment is sought on the extent (if any) of extra costs in maintaining a non-share capital account, particularly given the need of a company to keep accounting records and a franking account 4. There will be extra costs in maintaining a non-share capital account as this account is a statutory fiction, which does not fit into the relevant company's existing accounting records and almost certainly will be prepared for the company by their professional advisors. To imply that this is unlikely to be a significant burden because companies must keep accounting records presently is to ignore the fact that this is another compliance impost. Applicability of dividend-substitution provisions (section 45B ITAA 1936) It is the Taxation Institute s understanding that the release of the ATO Practice Statement on the application of section 45B is imminent. As the operation of section 45B in the context of the Discussion Paper is a fundamental issue, we question whether it is possible to have full and meaningful consultation on the section 45B aspects of the Discussion Paper until this Practice Statement is released and its contents analysed. There is insufficient public guidance available in relation to the application of Section 45B, and its potential application to the significant majority of at call loan situations where genuine loan amounts may be repaid to the lender is highly questionable. In 4 Page 6 of the Discussion Paper Page 5

7 particular, very often the mischief that is addressed by Section 45B is not something that is within the realm or capability of SME enterprise. Formalising the arrangement As indicated in our comments in response to Section 1 of the Discussion Paper, the reason loans between related parties are often left undocumented is because each party is usually controlled by the same people and any agreed terms could be changed quite readily. The suggested requirement to document loans between related parties is unnecessary as whatever the written terms they can be varied instantaneously. Moreover, the requirement to document loans will add further unnecessary compliance costs. That said, it is noted that the Discussion Paper seeks comments on the following two issues: 1. Section 45B The Discussion Paper indicates that section 45B problems can be overcome by formalising the loan arrangement. In this context, the Discussion Paper makes the following observation 5 : "Some representations have been made that this imposes an unnecessary compliance cost on the company." For the reasons outlined above, we question the need for documentation and would also note that in any event the likely number of entities that would have to address this issue is significant, resulting in an escalation of compliance costs. 2. Rationale for not documenting a loan relationship between a company and its shareholder(s) Comment is also sought on the rationale for not documenting a loan relationship between a company and its shareholder(s) 6. Subject to our comments in Section 1 above, in looking at this issue Treasury needs to be mindful of the contrast/distinction between contrived debt/equity hybrids, such as perpetual notes and income securities on the one hand, and informal loans entered into by all levels of businesses conducted in Australia. Bearing in mind that we are addressing the issue of costs of compliance, we make the following additional points: The suggestion in the Discussion Paper that loans should be documented to evidence their repayment within ten years is an unnecessary requirement that is dictated by a fiction that the debt/equity rules create. That is, it uses the net present value method for quantifying financial benefits where the loan is of ten years or more. All loans could be documented as being repayable within ten years and it would just help fulfil the fiction created by the law. Whether a loan is in essence a loan (eg repayable) or something which should be regarded as equity, is determined by the substance of the arrangement. The substance does not change for a genuine loan for either a period of nine years or eleven years. 5 6 Page 7 of the Discussion Paper Page 8 of the Discussion Paper Page 6

8 Accordingly, the requirement to document loans being repayable within ten years is unreasonable and, to most SME businesses in particular, lacking sufficient logic for them to want to incur loan documentation costs; and The characterisation of a financing arrangement as giving rise to a debt or equity interest happens at the time the interest is issued. This has to be done every time that a loan is made. Taking into account that in an SME business environment, at call loans may be made at short notice and frequently during any year of income, this has a potential to be an unacceptable requirement having no sensible cognisance of the way small business is done. Currently, from 1 July 2004, it will be a requirement to document properly the loan relationship prior to every advance being made. From this perspective, the law yet again results in an unnecessary compliance cost impost and may simply be unworkable. Therefore, the Taxation Institute urges Treasury to reconsider the documentation requirements in light of the above comments. In doing so, it is necessary to avoid the absolutely unnecessary situation where a large proportion of at call loans are required to be documented when there is no need to do so in order to achieve the policy underlying the debt/equity rules. Should documentation be considered necessary, a clear alternative to having every loan documented is to enforce some requirement akin to the recent changes to Division 7A. That is, a company should be allowed a period of time in which to have its at call loans properly characterised and the terms of the loan agreed to (and documented), so that their classification as debt or equity for taxation purposes is properly understood and is correct. In this regard, the Taxation Institute recommends that the company be given a time in respect of each year of income in which to have its documentation in place. Aligned to the new Subdivision EA requirements in Division 7A, this time limit might be the lodgment of the income tax return for the company for the year of income in question. In this context, clear guidance needs to be immediately given as to how pre-1 July 2004 loans need to be documented. Page 7

9 SECTION 3: Rationale for the debt/equity provisions in respect of specified at call loans It is noted that Treasury is seeking comments on the ways in which it might be possible to identify for possible exclusion from the debt/equity provisions specified at call loans that are used only for non-tax reasons. 7 There is a fundamental misunderstanding in the Treasury Paper that at call loans are used for tax reasons. This is not so. In light of our comments in response to Section 1 above, the Taxation Institute questions the rationale behind applying the debt/equity provisions to at call loans. Furthermore, we also doubt whether there really is a significant risk to either the integrity of the dividend imputation system or to the corporate tax base in Australia for at call loans, as considered in the Discussion Paper. 8 In this context, the Discussion Paper makes the following comments: 9 "...Such loans also provide an opportunity to flexibly manage the extent of deductions claimed by the company and, conversely, the amount of assessable income derived by an associated shareholder. As indicated above, a shareholder who controls the company may be able to determine how much interest, if any, is paid on such loans - particularly in a situation in which the loan may never be repaid." (italics supplied) The interest payable under an at call loan is determined by agreement between the parties and not unilaterally. Whether or not a loan is at call and whether or not it is documented, related parties can always vary the interest rate by agreement. At call loans between related parties have no tax advantage over any other type of loan between related parties. If interest is to be claimed by a company whose tax rate is 30%, then interest will be assessable to a lender at a tax rate which will, in many cases be higher than 30%. It is not the diminution in the corporate tax base which need be an issue here, but rather it is the overall loss to revenue, which may not in fact exist or be significant. In respect of the reference to loans that may never be repaid, there is no suggestion that this is the case for at call loans. There is clear distinction between at call loans and perpetual debt. To imply that at call loans may be perpetual is to misrepresent their nature. Accordingly, the policy objectives in relation to the integrity of the corporate tax base and the dividend imputation system are not materially enhanced by applying the debt/equity rules to at call loans, particularly in the SME environment Page 10 of the Discussion Paper Page 10 of the Discussion Paper Page 9 of the Discussion Paper Page 8

10 SECTION 4: Possible approaches for going forward It is noted that Treasury is seeking comments on ways to address concerns raised in respect of at call loans. Any strategies in going forward on this issue are predicated on a resolution of the fundamental question about whether or not Division 974 applies to at call loans in the first instance, and if so, whether or not there should be a carve out for SMEs. Therefore, subject to these reservations, we make the following comments in relation to the proposals put forward in the Discussion Paper. Raising Awareness of the requirements of the debt/equity provisions We support the recommendations in the Discussion Paper for raising the awareness of the debt/equity provisions amongst taxpayers in general, and in the SME sector in particular. To achieve this, the Discussion Paper canvasses the possibility of using an ATO education campaign. 10 It should be noted, however, that the ATO already has a considerable amount of material available on its website about the debt/equity provisions in general, and some specific information outlining the ATO s current views on the application of these provisions to at calls. Given our position on the at call loans issue as outlined in this submission, at this stage the Taxation Institute would not agree with many of the views expressed by the ATO in its current material in respect of at call loans. However, Treasury needs to be mindful that an ATO education campaign needs to be more than the production of more information. Clear strategies need to be developed that make taxpayers aware of the information in the first instance. Specific exclusion of specified at call loans from the debt/equity provisions The Taxation Institute is of the view that the proposed exclusion of specified at call loans from the debt/equity provisions based on a taxpayer s categorisation as an STS taxpayer is too narrow. Rather, the Taxation Institute recommends that a significant de minimis threshold in the existing debt/equity rules to prevent their application to SMEs whether eligible to qualify as an STS taxpayer or not. 10 Page 11 of the Discussion Paper Page 9

11 CONCLUSIONS For reasons outlined in our submission, to allow a full and proper period of consultation on the issues raised in the Discussion Paper, the transitional period in respect of at call loans should be immediately extended to expire on 30 June Furthermore, as a matter of urgency, Treasury should initiate the consultation process with interested parties, including the Taxation Institute, to consider concerns raised. With that in place, the Taxation Institute is of the view that: as a matter of law and economic reality, there are few if any circumstances in which an at call loan specified in the Discussion Paper qualifies as an equity interest. Division 974 should have no application to at call loans generally; and subject to our view that at call loans are by their nature not to be treated as equity, should this not be the case, then we strongly recommend that an appropriate carve out be made for SMEs in Division 974 in respect of at call loans. If you have any queries in relation to any matters raised in this submission please contact the Taxation Institute s Tax Director, Michael Dirkis on (02) Page 10