Tax Brief. 8 April Board of Taxation s Paper on the Debt and Equity Rules. 1. Background

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1 Tax Brief 8 April 2014 Board of Taxation s Paper on the Debt and Equity Rules The Board of Taxation has released a Discussion Paper as part of the review of the debt / equity rules commissioned by the previous government. This Tax Brief outlines the principal areas of focus of the Paper and the main issues it puts on the table for review. 1. Background In the May 2013 Budget, the then government announced that it would ask the Board of Taxation to undertake, a post implementation review of the debt and equity rules, which had been in place since The Discussion Paper released by the Board of Taxation is the first step in that process. This aspect of the Board s terms of reference are these rules working well? dominates the Paper. This focus is evident in the Board s articulation of the responses it is hoping the Paper will elicit from commentators: A key goal for the Board in issuing this discussion paper, is to identify issues with significant practical implications for businesses and/or administrators, or which involve significant risks to revenue, that warrant further consideration in the review process. The recommendations in the Board s final report will be focused on addressing these significant practical issues. The Paper asks that submissions, substantiate concerns they raise with representative examples of actual practical challenges. The 2013 Budget announcement also said the Board would be asked to consider, whether there can be improved arrangements within the Australian tax system to address any inconsistencies between Australia's and other jurisdictions' debt and equity rules that could give rise to tax arbitrage opportunities. The obvious reference was to the OECD s base erosion project (and its focus on mismatches in cross-border classification and treatment) which the previous government had enthusiastically embraced. This aspect of the Board s terms of

2 reference are our rules just too idiosyncratic given what other countries do? is less fully explored in the Paper. 2. Scope and focus The Discussion Paper is certainly compendious it is over 170 pages long. However, the early part of the document is largely descriptive describing the law prior to 2001, the theory behind the 2001 draft, the definitions adopted, the reactions of financial markets to the new rules, the extent of the guidance sought from and issued by the ATO, the (limited) experience of taxpayers before the Courts when these rules were involved, the approaches adopted in other countries, and the developments occurring in the international tax and economic framework after the 2008 financial crisis. The Paper then seeks responses on the matters which, it was expected, would form the core of the project: do the debt test and the equity test as currently drawn pose, any major practical difficulties for commercially significant arrangements? This question is refined by more precise questions focussing on particular elements of the debt and equity definitions and their area of operation. Those questions run to 12 pages. The questions are intended to elicit comments with respect to: the concept of a financing arrangement, the terrain covered by the critical notion of an effectively non-contingent obligation, the way the rules handle contingencies and subordination, practical difficulties in deciding when adverse economic consequences should lead to a conclusion that there is the substance or effect of an obligation, when, and how, the related scheme provisions work, whether characterising an instrument from the issuer s perspective is problematic for holders of instruments, the valuation rules, the discounting process and the particular formulation of the benchmark interest rate, issues in the application of the equity test, particularly deciding when an amount is contingent on economic performance, the way the rules approach changes to the terms of instruments after they have been issued, an entire chapter is devoted to the operation of s , the bête noire of the debt equity rules, and whether the amendments proposed almost 3 years ago but still not implemented will address the main concerns, 2 Board of Taxation s Paper on the Debt and Equity Rules

3 the interaction between the debt / equity rules and other provisions in the legislation, especially the TOFA rules, whether there are other areas of tax law where the debt and equity definitions should be used, in lieu of the current form-based terms, the particular problems in cross-border transactions arising from the incomplete use of the debt and equity definitions, and whether significant tax arbitrage opportunities arise from the differences between Australia s notions and those used in other jurisdictions. Each of these areas usually involves several sub-questions, and most ask whether this aspect of the current law is problematic. One is left with the impression that there must be very few parts of the current rules that are both clear and certain. In total, the Paper has 116 questions or requests for comment with 30 of these relating just to the mysteries of s including the following: Having regard to the issues identified with the current operation of section , would it be best to repeal section and introduce a more specific integrity measure that directly targets the mischief originally intended to be covered by the measure? While most of the questions focus on dissecting and examining what currently exists, some questions are not so constrained. One question asks whether there is a better model: Is there a different way of distinguishing between debt and equity characterisation for tax purposes, through a different legislative formulation, or through use of an independent process or body that could make the determination on a case by case basis? In this vein, another question asks whether the domestic law should simply be aligned to the classifications used by APRA for entities regulated by APRA so as to ensure that all Tier 2 instruments receive debt treatment for tax purposes. Banks will also be very interested in this comment: Some stakeholders, in particular the banking industry, argue that the current ATO interpretation being applied to section has rendered the section unworkable and inconsistent with its purpose. This view is not shared by the ATO and the Treasury, who have both confirmed that the outcome reached in the TD [TD 2012/19] is consistent with the policy rationale for section And, even after 12 pages of questions, the Paper leaves open the possibility that it has missed something: 3 Board of Taxation s Paper on the Debt and Equity Rules

4 Are there any other issues with the operation of Division 974 that the Board has not raised in this discussion paper? 3. Some comments Many documents emerge from their authors with a clear, if unstated, agenda. Readers can infer what is likely to happen by looking at what is left off the agenda or at how the issues are framed. While those documents claim to be inviting comments, it is clear the major decisions have already been made. The Discussion Paper is not such a document. The questions are as broad as one could conceive and it is hard to think of an aspect of the debt / equity rules that has been overlooked. Nor does the Paper hint that the Board has reached some tentative conclusions which it is trialling here to see if there will be loud and vociferous complaint. Instead, people are given free rein to comment on anything. If there is a hidden agenda, it is very well hidden indeed. At this stage, perhaps the only predictions one can make with any confidence are (i) a statutory debt and equity definition will survive, and (ii) it will likely be more universally applied in the tax legislation than is currently the case. While the Board is to be commended for the ambitious breadth of this Paper, it does bring some dangers. First, it is hard to predict where this process will end up and even harder to see this process being wrapped up quickly. There may need to be several more of these Papers before one can see any clear trends will the recommendation be for minor tinkering or wholesale demolition, if tinkering, which bits are in peril, what direction will be taken on s , and so on? And the unrestricted agenda does not sit easily with the timetable set by the government the Board s final report is due to be submitted to the government by the end of March It also makes the tasks of commenting on the Paper, and the Board s task of evaluating those comments, more difficult. Commentators are, in effect, being offered the opportunity to invite the Board to recommend to government everything from, the entire regime should be scrapped, to these major chunks of the existing law have to be revised, to tinker with just this handful of concepts and terms. Some commentators may conclude that their best strategy is to seek a few key reforms in the hope that they might happen; others may hope for more ambitious reform, even at the risk of a protracted process. How the Board will process the widely disparate responses it is likely to generate will be interesting to observe. 4. Next steps The Board is seeking comments on the Paper by 23 May 2014, and proposes holding consultation meetings with stakeholders. 4 Board of Taxation s Paper on the Debt and Equity Rules

5 For further information, please contact: Sydney Tony Frost phone Tim Kyle tim.kyle@gf.com.au phone Richard Hendriks richard.hendriks@gf.com.au phone Melbourne Cameron Rider cameron.rider@gf.com.au phone Richard Buchanan richard.buchanan@gf.com.au phone Perth Nick Heggart nick.heggart@gf.com.au phone G&F document ID _2.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax Board of Taxation s Paper on the Debt and Equity Rules