Debt/Equity: Recent Developments

Transcription

1 Debt/Equity: Recent Developments Presented by Martin Fry and Brad Schwarz (December 2005) Martin Fry Partner Allens Arthur Robinson Melbourne Brad Schwarz Senior Associate Allens Arthur Robinson Melbourne mafm M v Page 1

2 Table of Contents 1. Debt/Equity in Context 3 2. This Paper 4 3. Debt/Equity Outline Objects of Division Equity Debt 6 4. Experiences in Other Countries New Zealand Canada United States of America Australian Perspective TD 2004/D76: Issuer's option to convert Scope of the Willingness Exception Reclassify Solvency Clauses Section Conceptual Limbs of Section The Equity Limb Designed to Operate Third Party Finance Another Person Apportionment 26 mafm M v Page 2

3 1. Debt/Equity in Context The distinction between debt and equity is of fundamental importance in modern commercial activity. One of the core principles upon which financial accommodation is obtained for commercial ventures is that those exposed to the risk of the venture failing should also be entitled to the fruits of the venture's success, whilst those having the benefit of protection from failure should therefore be excluded from the fruits of success. Within this broad spectrum, parties come together to participate in commercial ventures and myriad financial arrangements are created under which the risks and rewards of the venture are allocated amongst the participants on the basis of their respective appetites for risk and reward. This allocation of risk and reward determines at a basic level whether we regard any particular party as an equity participant or debt participant in the venture. The reality of modern financial arrangements is that any particular party will often have a mixture of equity-like and debt-like exposures to the venture. A fundamental question for regulators is whether financial arrangements should be viewed as a whole from a debt/equity perspective, or whether financial arrangements should be dissected into their separate 'debt parts' and 'equity parts'. Once it has been decided that financial arrangements should be viewed as a whole, the challenge is to appropriately characterise the overall arrangement as debt or equity having regard to the inevitable mix of equity and debt exposures. Although the task of characterising arrangements as debt or equity will often be difficult, the debt/equity distinction continues to be a key area of focus in the Australian economy. Ratings agencies and prudential regulators such as APRA closely monitor the debt to equity ratios of Australian corporations. When accountants draw up financial accounts for a corporation they record the levels of debt and equity, and this information is relied upon by the investment market. The distinction between debt and equity is alive in many aspects of our income tax laws. Division 974 of the Tax Act 1997 provides a code for determining whether a scheme is to be characterised as debt or equity for some but not all income tax purposes. Division 974 is generally relevant for the purposes of the following (which is not an exhaustive list): (a) dividend imputation (section and Division 215 of the Tax Act 1997); (b) dividend and interest withholding tax, including the interest withholding tax exemption for public offers (sections 128A(1), (1AB) and 128F of the Tax Act 1936); (c) thin capitalisation (Division 820 of the Tax Act 1997); (d) certain deduction provisions (sections and and of the Tax Act 1997; (e) the non-share capital account (Division 164 of the Tax Act 1997); (f) membership interests for tax consolidation purposes (section of the Tax Act 1997); mafm M v Page 3

4 (g) exempting company provisions (section of the Tax Act 1997, but note the extension of the debt/equity distinction in section (6)); (h) assessment of dividend income under section 44 of the Tax Act 1936; (i) taxation of tax exempt bonus shares (section 6BA of the Tax Act 1936); (j) commercial debt forgiveness provisions (Division 245, Schedule 2C of the Tax Act 1997); (k) tax file number provisions (section 202D of the Tax Act 1936). However, at the same time the debt/equity distinction provided by Division 974 has no role to play in many instances in which the distinction between debt and equity is relevant to the application of our tax laws. For example, the debt/equity distinction under Division 974 has no role to play in relation to the following: (a) scrip for scrip rollover relief (Division 124-M of the Tax Act 1997); (b) grouping other than for the purposes of tax consolidation (eg, CGT rollover relief under Division 126-B of the Tax Act 1997); (c) controlled foreign company provisions (Part X of the Tax Act 1936); (d) the CGT participation exemption (Division 768 of the Tax Act 1997); (e) accruals taxation under Division 16E of the Tax Act 1997; (f) the definition of a 'qualified person' for the purposes of the franking provisions (Part IIIAA, Division 1A of the Tax Act 1936 as at 30 June 2002); (g) the exemptions provided by sections 23AJ, 23AI and 23AK of the Tax Act This Paper This paper will focus on the debt/equity distinctions contained in Division 974 of the Tax Act The purpose of this paper is to provide commentary on recent developments in the application of Division 974 and to comment on experiences in dealing with the distinction between debt and equity in certain foreign jurisdictions. Part 3 of this paper provides a brief summary of the debt/equity distinction in Division 974. The distinction has also been well described in other places, such as the recent articles by Garry Bourke 1 and Stuart O'Neill 2. Part 4 of the paper then briefly considers the debt/equity experience in the United States, Canada and New Zealand, and reflects upon these experiences in the context of Division 974. Part 5 provides a critique of the Draft Taxation Determination TD 2004/D76. 1 'Drawing a sharp line in the sand of the debt/equity desert Division 974 Oasis or Mirage?' (2004) 33 Australian Tax Rev 'Criticisms of the Debt-Equity Rules and their Application to Modern Financial Instruments', The Tax Specialist, Vol. 6 No 4, April mafm M v Page 4

5 Part 6 is a discussion of so-called solvency clauses and the announced proposal to deal with the issues raised by such clauses. Finally, Part 7 of this paper discusses the ambit of section In this paper, all statutory references are to the Income Tax Assessment Act 1997 (Tax Act 1997) or the Income Tax Assessment Act 1936 (Tax Act 1936), unless stated otherwise. 3. Debt/Equity Outline Division 974 of the Tax Act 1997 contains prescriptive rules to determine what constitutes debt and what constitutes equity in a company for certain income tax purposes. In broad terms, the objective of these rules is to characterise instruments on the basis of their economic substance rather than on the basis of their legal form. Consequently, instruments which in form are equity may be characterised as debt under Division 974, and instruments that are in form debt can be characterised as equity. A flow chart of the debt/equity distinction in Division 974 is set out in Appendix 1. As a general proposition, if an interest satisfies the debt test, distributions paid on that interest may be deductible but not frankable and will potentially be subject to interest withholding tax. Conversely, distributions paid on equity interests may be frankable but not deductible and will potentially be subject to dividend withholding tax. The key question in characterising an instrument as debt or equity is whether the issuer of the instrument has an effectively non-contingent obligation to pay back an amount that is at least equal to the amount it received in connection with the issuance of the instrument. If there is such an obligation, the instrument is treated as debt. If there is no such obligation the instrument will be treated as equity if it represents the interest of a member of the issuer, now or in the future, or if the return on the instrument is contingent on the issuer in certain respects. There is scope for overlap between the debt and equity definitions. If an instrument satisfies both definitions, it is treated as debt. In conducting the task of characterising an instrument it is necessary to have regard to related arrangements. As for the meaning and application of effectively non-contingent obligation, this expression is currently the subject of debate. We have considered its meaning and application in Parts 5 and 6 of this paper in the context of convertible notes and solvency clauses. 3.1 Objects of Division 974 The stated objects of Division 974 are: (a) (b) to establish a test for determining for particular tax purposes whether a scheme or the combined operation of a number of schemes gives rise to a debt interest or an equity interest; that the test operates on the basis of economic substance rather than on the basis of mere legal form (by reference to the impact on the issuer's position); mafm M v Page 5

6 (c) (d) that the combined effect of related schemes be taken into account in appropriate cases (to ensure that the test operates effectively on the basis of economic substance and to prevent the test being circumvented by entering into separate schemes); and to identify the distributions and credits made in respect of non-share equity interests in a company that are to be treated as dividends and those that are to be treated as returns of capital. In making various determinations under Division 974, the Commissioner must have regard to these stated objects (section ). 3.2 Equity Section lists the following four categories of interests in relation to a company which are treated as equity: (a) (b) (c) (d) An interest in a company as a member or stockholder. An interest carrying a right to a variable or fixed return if either the right itself or the amount of the return is in substance or effect contingent on the economic performance of the company, a part of the company s activities or a connected entity of the company. An interest that carries a right to a variable or fixed return if either the right itself or the amount of the return is at the discretion of the company or a connected entity of the company. An interest issued by a company that gives the holder (or a connected entity of the holder) a right to be issued with an equity interest in the company or in a connected entity of the company, or that will or may convert into an equity interest in the company or a connected entity of the company. For interests other than an interest in a company as a member or stockholder, to constitute an equity interest, the particular scheme under which the interest arises must involve a financing arrangement. That concept is very broadly defined. Basically, a scheme is a financing arrangement if it is undertaken to raise finance for the entity or for a connected entity (section ). An equity interest can arise under a single scheme. It is also provided that two or more related schemes are taken together to give rise to an equity interest in a company if a scheme with the combined effect of the constituent schemes would give rise to an equity interest and it is reasonable to conclude that the company intended, or knew that a party to the schemes intended, that the combined economic effect of the constituent schemes would be the same as, or similar to, the economic effects of an equity interest (section ). 3.3 Debt According to section , a scheme satisfies the debt test in relation to an entity if: (a) it is a financing arrangement for the entity (financing arrangement has the same meaning in this context as it does for the purpose of the equity interest definition); mafm M v Page 6

7 (b) (c) (d) (e) the entity, or a connected entity, receives or will receive a financial benefit under the scheme; the entity, or the entity and a connected entity, has an effectively non-contingent obligation to provide a financial benefit after the time when it first receives a financial benefit; it is substantially more likely than not that the value provided by the entity will be at least equal to the value it received; and the value provided and the value received are not both nil. As discussed above in relation to equity interests, debt interests can arise under a single scheme or under related schemes the combined effect of which, and the intention of which, is to create a debt interest. Financial benefit is defined as meaning anything of economic value, and includes property and services (section ). The issuing of an equity interest does not constitute the provision of a financial benefit (section ). Therefore, the issuance of an equity interest on conversion of a convertible note would not be taken into account in determining whether the issuer has an effectively non-contingent obligation to provide financial benefits at least equal to the benefits it receives. An obligation to take a particular action is effectively non-contingent if, having regard to the pricing, terms and conditions of the scheme there is in substance or effect a noncontingent obligation to take that action (sub-section (1)). As this is a key concept in Division 974, there are also a number of specific rules on whether a particular obligation is to be regarded as effectively non-contingent. In particular: (a) (b) (c) (d) An obligation is taken to be non-contingent if is not contingent on any event, condition or situation other than the ability or willingness of the entity to meet the obligation (sub-section (3)). Obligations to redeem preference shares are not taken to be contingent merely because there is a legislative requirement to redeem the shares out of profits or from the proceeds of a further issuance of shares (sub-section (5)). The fact that the holder of an interest that is convertible into equity has a right to convert the interest into equity does not of itself make the issuer s obligation to repay the interest contingent (sub-section (4)). For example, the issuer of a convertible note where the issuer has an obligation to repay the amount raised on issuance may have a non-contingent obligation to repay that amount even though the holder may be entitled to exercise a conversion right at specified times during the term of the note. An obligation is not taken to be effectively non-contingent merely because the issuer will suffer a detrimental practical or commercial consequence if the obligation is not fulfilled (sub-section (7)). In this context, the legislation uses income securities as an example. It states that if there is a contingent obligation to make payments on income securities (eg. interest is only payable if sufficient profits are available), the obligation to make payments is not non- mafm M v Page 7

8 contingent merely because non-payment would have a detrimental effect on the issuer s business. (e) In determining whether there is in substance or effect a non-contingent obligation, it is necessary to have regard to the artificiality or the contrived nature of any contingency on which the obligation to take the action depends (sub-section (6)). Division 974 contains rules for valuing financial benefits. This is important in determining whether it is substantially more likely than not that the value of the benefits to be provided by the issuer will at least equal the value of the financial benefits received. If the issuer has an effectively non-contingent obligation to provide financial benefits in relation to an interest no later than 10 years after the interest is issued, the value of those financial benefits is to be calculated in nominal terms (section ). If there is an obligation to provide benefits for a period exceeding 10 years from the date of issue, the value of the benefits is determined in present value terms. For this purpose, future payment streams are discounted at a rate equal to 75 percent of the rate of interest paid on the issuer s ordinary debt (section ). 4. Experiences in Other Countries It is instructive to consider the approach to the debt/equity distinction in other countries. 4.1 New Zealand The New Zealand tax system has featured an accruals taxation regime for some time, and the New Zealand approach to the debt/equity distinction is encapsulated in the carve out from accruals taxation that is provided for shares and certain interests in shares. The accruals regime applies to 'financial arrangements', which are very broadly defined to include an arrangement under which a person receives anything of value in consideration for a person providing in the future anything of value to any person 3. However, an arrangement is then carved out of the accruals regime if it is covered by one of the 22 'excepted financial arrangements'. The list of 'excepted financial arrangements' includes shares (defined to include any interest in the capital of a company, and certain debentures) and certain options to buy or sell shares 4. When considered in light of the Australian debt/equity distinction in Division 974, the most striking aspect of the New Zealand approach is the fact that the 'equity' carve out relies upon the legal form of the instrument. The issues which arise under Division 974 in applying the 'effectively non-contingent obligation' test and other tests based upon the economic substance of the arrangements do not have a significant role to play in the New Zealand debt/equity distinction. 3 Section EW3(1), (2), Income Tax Act Sections EW4, EW5, Income Tax Act mafm M v Page 8

9 As noted by Bourke 5, it is interesting to note that under the Australian debt/equity distinction in Division 974 an instrument which satisfies both the debt test and the equity test will be classified as debt (sections (1)(b) and (2)), whereas under the New Zealand approach 'equity' instruments (specifically, shares and certain options to buy or sell shares) are carve out of the accruals regime for 'financial arrangements'. It has been suggested that the New Zealand approach of specific carve-outs gives the legislature the flexibility to respond to the development of new forms of financial instruments in the market over time 6. This is also a feature of the Australian debt/equity distinction in Division 974, with the Commissioner having the power to make regulations in relation to many aspects of the debt/equity distinction (refer sections (6), (6), , (8), (2), (3), (4), (4) and (3)). The current proposals to deal with so-called 'solvency clauses' is evidence of this feature at work refer Part 6 of this paper below. However, a related aspect of the Australian debt/equity Rules can only be viewed as negative. Specifically, the ability of the Commissioner to determine the debt/equity classification notwithstanding the classification that is achieved by the debt and equity tests set out in Division 974 introduces an unnecessary degree of uncertainty into the Australian regime (refer sections (4), , (4) and (2); the Commissioner's determination under section is perhaps not subject to this criticism). 4.2 Canada The Canadian tax laws contain provisions which apply debt tax treatment to certain preference shares 7. Specifically, certain preferred shares are deemed to be debt for tax purposes where the terms and conditions of the share issue make it 'reasonable to expect' that the issuer or a related person will redeem, acquire or cancel the share. As noted by Bourke, the Canadian concept of 'reasonable to expect' may well be a better vehicle for giving recognition to the economic substance of an arrangement than is the Australian 'effectively non-contingent obligation' test, as the use of the legal term 'obligation' in the Australian test is more likely to give prominence to the legal form of the arrangement. It is noted that the Canadian test focuses on the likelihood of redemption, and the Australian debt test, broadly speaking, focuses on whether there is an effective obligation for the issuer to return the investor's investment by way of redemption or coupons. This focus on the likelihood of the issuer returning the funds invested is in contrast to the approach of the Full Federal Court in FCT v Radilo Enterprises Pty Ltd 97 ATC 4123, where the question of the issuer having an obligation to redeem the preference shares was 5 G Bourke, 'Drawing a sharp line in the sand of the debt/equity desert Division 974 Oasis or Mirage?' (2004) 33 Australian Tax Review Smith 'AMC New Zealand Taxation of Financial Instruments' (1999) 6 (Nov/Dec), Derivatives and Financial Instruments (IBFD Publications BV), cited in Bourke at note Bourke, (2004) 33 Australian Tax Review 24 at p.50. mafm M v Page 9

10 one factor taken into account, but where the court placed far more emphasis on the broader question of whether a relationship of creditor and debtor existed between the issuer and the investor. 4.3 United States of America The approach to the debt/equity distinction in the United States provides a stark contrast to the Australian approach in Division 974. In broad terms the distinction between debt and equity for US tax purposes is determined by a 'facts and circumstances' approach 8. Under this approach the courts extract the equity-like characteristics and the debt-like characteristics of an arrangement, weigh up these characteristics amongst each other, and then determine whether the arrangement is debt or equity without regard to any single articulated principle. The following statement has been cited in the US courts as the classic statement of that which differentiates a shareholder from a creditor 9 : the shareholder is an adventurer in the corporate business; he takes risks, and profits from success. The creditor, in compensation for not sharing in profits, is to be paid independently of the risk of success, and gets a right to dip into the capital when the payment date arrives. It has been suggested that this and other judicial pronouncements provide no meaningful guidance on how to distinguish between debt and equity for the purposes of US law 10. Indeed, the state of the law in the US on the debt/equity distinction has been described in the following terms 11 : because of the wide variety of instruments and transactions that have required classification as debt or equity, the courts have spawned a bewildering variety of tests and standards requiring highly fact-bound and uncertain legal determinations. One commentator counted thirty-eight different factors that had been considered by the courts in trying to classify an interest as debt or equity. Another stated that "[t]o look to the case law for guidance is to invite bewilderment. You can find a case which supports almost any reasonable argument." Finally, a district court judge stated that the distinction was reminiscent of Justice Stewart's well-known "definition" of pornography 12 The 'thirty-eight factors' referred to above were as follows: 8 Katherine Pratt 'The Debt-Equity Distinction in a Second-Best World', Vanderbilt Law Review, Vol 53, No 4, May 2000; Gordon Longhhouse, 'Making the Line a Gap: Edgar's Treatment of the Debt-Equity Boundary', Canadian Tax Journal (2002) Vol. 50 No 1, Adam Emmerich, 'Hybrid Instruments and the Debt-Equity Distinction in Corporate Taxation', University of Chicago Law Review, Vol 52, 1985, 118 at p.121 and note 42; quote from the decision in Commissioner v OPP Holding Corp 76 F.2d 11 (2d Cir 1935). 10 Emmerich at p Emmerich at p Sansberry v United States, 25 A.F.T.R.2d (P-H) , at n.4 (S.D. Ind. 1970) (citing Jacobellis v Ohio, 378 U.S. 184, 197 (1964) (Stewart, J., concurring) ("I know it when I see it "); see also Plumb, supra note 5, at (discussing the "jungle" of conflicting decisions and criteria). mafm M v Page 10

11 formal authorisation of "debt"; ascertainable principal amount; time to maturity; postponement of stated maturity; default provisions; default provisions not being invoked; specificity of interest provisions; source of interest; discretion of obligor in paying interest; "understanding" as to nonobservance of terms; cumulativeness of interest; possibility of unilateral modification; specificity of rights upon dissolution; subordination; dependency of repayment on success of business venture; identity of interest between stockholders and bondholders; nature of creditor; dependency of interest upon director action; participation of bonds in profits; creditor participation in management; package financing of the corporation; whether debt was really a conversion of equity; whether the original capital was adequate; timing of the creation of the indebtedness; thinness of capital; form of the instrument; uncertainty of obligor as to what the security is; ability of borrower to borrow from nonstockholders; creditors expectation of repayment; how the obligor carried "debt" on its books; corroborative evidence; convertibility of indebtedness; nomenclature; industry practice; whether the indebtedness was secured; existence of a sinking fund; pattern of stockholder borrowing; and intent 13. It is interesting to note that a number of the thirty-eight factors are also features of the debt test or equity test in Division 974. A review of the literature in relation to the US debt/equity distinction reveals the consistent criticism that the 'facts and circumstances' approach produces an unacceptable level of uncertainty and associated compliance costs. On the other hand, and relevantly in the context of the 'sharp line' approach to the debt/equity distinction that is adopted in Division , it is also said that the key benefit of the US 'facts and circumstances' approach is that it avoids the financial engineering that naturally follows from having a 'sharp' dividing line between debt and equity 15. Over time we will know whether the comprehensive set of rules contained in Division 974 deliver a materially better outcome than the much more fluid 'facts and circumstances' approach. However, it is most relevant to note that the US regulators have previously attempted to establish a 'sharp line' distinction between debt and equity. This occurred in 1980 when, pursuant to section 385 of the US tax code 16, regulations were proposed to provide guidelines for classifying instruments as debt or equity for tax purposes. In relation to 'hybrid instruments' the proposed regulations provided that the instrument would be debt if its 'debt features' accounted for more than 50% of the value of the instrument. The 'debt features' were effectively defined to be the present value of the fixed or guaranteed amounts payable under the instrument 17. The investment market responded to the proposed regulations in the early 1980s by crafting hybrids then known as 'adjustable rate convertible notes', which provided for 13 Emmerich at note 43, citing Holzman, The Interest-Dividend Guidelines, 47 Taxes 4 883, 885 (1969). 14 Bourke, at p Gordon Lighthouse, 'Making the Line a Gap: Edgar's Treatment of the Debt-Equity Boundary', Canadian Tax Journal, 2002 Vol. 50, Iss. 1, p.238; Tim Edgar 'The Income Tax Treatment of Financial Instruments: Theory and Practice', Canadian Tax Paper no. 105, Canadian Tax Foundation, IRC s.385(a); refer also Pratt at notes 106 to Emmerich at pp mafm M v Page 11

12 guaranteed payments having a present value marginally exceeding 50% of the value of the notes, but which also provided for variable payments linked to the issuers' dividends and which were convertible into ordinary shares 18. The IRS responded to this development by issuing Revenue Ruling in which it advised that the adjustable rate convertible notes were to be treated as equity for tax purposes on the basis that the notes were virtually certain to be converted to shares and that the debt features were of little 'practical or economic significance' 19. However, having deferred the commencement date for the Regulations, the IRS then retreated from the 'sharp line' approach entirely when it withdrew the Regulations in 1983 and the US tax law on the debt/equity distinction returned to the murky waters of the 'facts and circumstances' approach 20. The lesson to be gained from the 'section 385 experiment' in the US is that the Australian revenue authorities should not be surprised if the market responds to the prescriptive debt/equity distinction in Division 974 by placing a greater emphasis on financial engineering, and perhaps legal form, in constructing hybrid financial instruments. Interestingly, Gordon Mackenzie of the University of New South Wales has conducted an empirical study from which he draws the conclusion that the introduction of Division 974 has been substantially responsible for the increase in the issuance of hybrids in the period since Of course, an increase in the issuance of hybrids should not necessarily be viewed as a negative by revenue authorities, as the hybrid instrument provides a means of effective risk allocation for certain market participants. Indeed the Australian revenue authorities may even wish to assert that an increase in hybrid issuance is evidence of Division 974 providing certainty and clarity on the debt/equity distinction! 4.4 Australian Perspective When one considers the approaches to the debt/equity distinction in the US, New Zealand and Canada, the Australian debt/equity distinction in Division 974 is remarkably comprehensive and prescriptive. In particular, the machinery, concepts and complexities of Division 974 of the Tax Act 1997 are extraordinary when one considers that the US tax system survives with the bare minimum of guidance from the legislature. This raises the question of whether it is really necessary for the Australian tax laws to be saddled with such a comprehensive and involved code for distinguishing between debt and equity for tax purposes. In this respect the following thoughts are offered. First, whilst Division 974 of the Tax Act 1997 provides a detailed and prescriptive code for distinguishing between debt and equity, the characterisation of an instrument under Division 974 has not been comprehensively integrated into our tax laws. It is suggested that the legitimacy of the comprehensive approach embodied in Division 974 could only be 18 Emmerich at p.131, citing Borg-Warner Corporation Prospectus 2 December Emmerich at pp Emmerich at p.132; Longhouse at note 27; Bourke at p.31; Pratt at p.1083 and note Gordon Mackenzie, 'Impact of new debt/equity rules on the hybrid capital market an empirical study', Australian Banking and Finance Law Bulletin, Vol. 20 No. 7, January mafm M v Page 12

13 established if the debt/equity characterisation under Division 974 were to be applied comprehensively throughout the Tax Act 1997 and the Tax Act Second, it is relevant to recall that legislative rules to distinguish between debt and equity exist partly in response to the difference in the after-tax cost of debt funding and equity funding. In jurisdictions where there is no general tax relief for dividends received, such as the United States, there continues to be a comparatively large difference in the after-tax cost of debt funding compared to equity funding. By contrast, in Australia the after-tax cost of debt funding and equity funding is more closely aligned. This is a consequence of the Australian dividend imputation rules, which provide the shareholder with a credit for the tax paid at the entity level. It is also a consequence of the preference provided to the taxation of value gains in the hands of equity holders. That is, in comparative terms equity interests pay more of their returns as capital gains than do debt interests, and such capital gains are only taxed in the hands of equity holders upon realisation of the capital gain. Even then, the equity holder's capital gain will often be entitled to the benefit of the CGT discounts (refer Division 115 of the Tax Act 1997). Hence, in circumstances where the gap between the after-tax cost of debt funding and equity funding is comparatively narrow, is there a case for the Australian tax laws to contain the comprehensive code embodied in Division 974? In other words, consideration should be given to the question of whether the prospects of parties engaging in domestic debt/equity arbitrage are sufficient to justify the comprehensive and complex approach adopted in Division 974. Third, as Bourke points out, the debt/equity distinction in Australia is out of alignment with other major countries 22. A disparity in treatments between two jurisdictions will, of course, create the opportunity for cross-border debt/equity arbitrage. As put by Rosenbloom: Whenever a country adopts a rule that is either difficult to replicate or apply (for example the US rules for distinguishing debt from equity) or markedly out of step with what other countries do or are likely to do, a breeding ground for arbitrage is created. The next issue to consider in this context is whether international arbitrage should or should not be a concern for the legislature of any one country. If a financial arrangement satisfies the criteria for classification of debt or equity for Australian tax purposes, do the Australian Parliament or revenue authorities have any legitimate concern if the same arrangement is treated in a different way for tax purposes in another country? That topic is beyond the scope of this paper, however Rosenbloom's analysis of this issue is recommended Bourke, at p Rosenbloom HD, 'International Tax Arbitrage and the International Tax System'. NYU Tax Law Review 153. mafm M v Page 13

14 5. TD 2004/D76: Issuer's option to convert Section of the Tax Act 1997 contains five key tests that must be satisfied in order for an interest in an entity to be treated as debt. One of those tests is that the entity must have an effectively non-contingent obligation to provide a financial benefit or benefits (sub-section (1)(c) of the Tax Act 1997). This part of the paper considers the application of this test in the context of an interest bearing convertible note. In this regard, Draft Taxation Determination TD 2004/D76 (Draft Tax Determination) raises the following question: for the purposes of Division 974 of the Income Tax Assessment Act 1997, does an issuing company have an effectively non-contingent obligation to provide a financial benefit by way of periodic interest returns on an interest bearing convertible note from the time that it can be converted at the issuing company's option into ordinary shares in that company? The answer provided is: no, unless the option to convert should be disregarded in light of the full consideration of the pricing, terms and conditions of the scheme under which the convertible note was issued. The significance of this interpretation can be illustrated as follows: Company issues convertible notes Company has option to convert convertible notes into ordinary shares Company exercises option 17 November November November 2014 (a) (b) (c) On 17 November a company (issuer) issues convertible notes. Under the terms of the notes, the issuer is required to pay periodic coupons at a fixed rate until the notes convert into ordinary shares, which may occur at the issuer's option at any time on or after 17 November On 17 November the option to convert the convertible notes into ordinary shares crystallises (that is, the issuer can exercise the option at any time). On 17 November the issuer exercises the option and converts the convertible notes into ordinary shares. The Draft Tax Determination correctly notes that the requirements of section must be tested at the date of issue of the convertible note. According to the Draft Tax Determination, the issuer will cease having an effectively noncontingent obligation to pay the coupons on the convertible notes from 17 November That is, from the time the option to convert the convertible notes into ordinary shares crystallises, even though it may ultimately be the case that the issuer continues to pay the coupons and the actual conversion does not occur until three years later. The reason for this, according to the Draft Tax Determination, is that at the time the option crystallises the payment of the coupons becomes contingent upon the issuer not exercising the option and, mafm M v Page 14

15 therefore, not converting the convertibles notes into ordinary shares (paragraph 9 of the Draft Tax Determination). The potential implications of the Draft Tax Determination are: (a) (b) if the convertible notes do not otherwise satisfy the debt test under Division 974 at the time of issue 24 - the effect of the Draft Tax Determination would mean that the convertible notes would be treated as equity from the outset, even though the notes had a clear debt like character at least until 17 November 2011; if the convertible notes otherwise satisfy the debt test under Division 974 at the time of issue 25 the effect of the Draft Tax Determination would mean that the notes will lose their status as debt at the time the issuer can exercise the option (ie. from 2011) as there would no longer be a debt interest on issue (section (1)(e)). Consequentially, the notes may be treated as equity and the payment of the coupons may no longer be deductible, but may be frankable, from 17 November 2011 to 17 November 2014 (section 26-26). It is questionable whether the interpretation adopted in the Draft Tax Determination adequately takes into account the requirements set out in section and the other provisions in Division Scope of the Willingness Exception According to sub-section (1), there is an effectively non-contingent obligation to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action. According to sub-section (3), an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation. It is evident from the wording in sub-section (3) that, in order for an obligation to be non-contingent, all events, conditions or situations must be taken into account other than the ability or willingness of the entity or connected entity to meet the obligation. In other words, the section contains a positive limb and a negative limb. The positive limb is subject to the negative limb. If you satisfy the positive limb, the conditions of the subsection will only be met if you do not fail under the negative limb. In the ordinary circumstances where an issuer has an unfettered option to convert convertible notes into ordinary shares, but chooses not to do so, it seems that the only likely reason for this is the issuer's willingness to continue to allow the convertible notes to exist and, therefore, the issuer's willingness to continue to pay the coupons under the notes. Accordingly, it can be said that where an issuer has the option to convert convertible notes into ordinary shares, but chooses not to do so, the issuer's obligation to 24 For example, because it is not substantially more likely than not that the coupon payments from 2005 to 2011 will be at least equal to the issue price of the convertible notes 25 For example, because it is substantially more likely than not that the coupon payments from 2005 to 2011 will at least equal the issue price of the convertible notes. mafm M v Page 15

16 pay interest remains non-contingent as the only event, condition or situation affecting the issuer is its willingness to meet the relevant obligation. If this interpretation is correct, then in the above example 17 November 2014 would be the time when the issuer's obligation to pay interest would no longer be non-contingent. That is, at the time the convertible notes were actually converted into ordinary shares. This view is clearly consistent with the commercial objectives and features of the convertible notes. It is also consistent with sub-section (1), which provides that if a debt interest is an interest that will or may convert into an equity interest, the conversion is taken, for the purposes of this Division, to give rise to a new interest (and is not merely treated as a continuation of the debt interest). In contrast, it appears that the approach adopted in the Draft Taxation Determination overlooks the negative limb in sub-section (3). That is, it fails to take into account the 'willingness' exception. If the 'willingness' exception is not operative here to ignore the possibility of the issuer exercising the option to convert the notes, then the question is what the willingness exception is intended to cover. Of course, all contractual obligations are ultimately contingent on the obligor's willingness to perform such obligations. Is the scope of the 'willingness' exception limited to an issuer's willingness to comply with its contractual obligations under the relevant instrument? That would seem to be an absurdly limited view of the exception, and contrary to subsection (1) and section which direct us to consider matters of substance having regard to pricing, terms and conditions. It must be acknowledged that the outcome of the Commissioner's view in the Draft Tax Determination would be an appropriate outcome if the terms of issue of the notes required the issuer to pay a punitive coupon rate in the period after the date on which the issuer became entitled to exercise the option (for example if there were to be a substantial stepup in the coupon after 17 November 2011). However, it is unfortunate that the Draft Tax Determination is silent on whether it is directed at situations in which the issuer would be subject to a punitive coupon rate and so would be 'economically motivated' to exercise the option. However, even if it is accepted that it is appropriate to ignore the obligation to pay coupons after a step-up, it would remain necessary to deal with the role of the 'willingness' exception. That is, if we accept that the appropriate treatment is to ignore the coupon payments after the date on which the stepped-up coupon is effective (ie, after 17 November 2011), then we are really saying that the virtual certainty of the issuer exercising the option means that in substance the obligation to pay coupons after 17 November 2011 can be ignored for the purposes of applying the debt test. This outcome of ignoring the obligation to pay coupons should be achieved by the following words in the definition of 'effectively non-contingent obligation' in section (1): there is in substance or effect a non-contingent obligation However, even then the reason why we say that in substance the obligation can be ignored in the period after the step up is because it is virtually certain that any issuer will not be willing to pay the higher coupons. Hence, it is still necessary to reconcile this appropriate outcome with the role of the 'willingness' exception. mafm M v Page 16

17 It may be argued that this outcome of ignoring the obligation to pay coupons after the stepup might be achieved by section (3), which provides (albeit in the context of valuing the effectively non-contingent obligations) that if the issuer: does have an effectively non-contingent obligation to exercise the right or option, the life of the interest ends at the earliest time at which the [issuer] will have to exercise the right or option. [Our emphasis.] The difficulty with using section (3) as the basis for ignoring the coupons after the step-up is that the phrase 'effectively non-contingent obligation' is then defined in section by reference to whether there is in substance or effect a non-contingent obligation. The word obligation has a legal meaning which is usually associated with a legally enforceable obligation such as a contractual obligation. Although the issuer is 'economically motivated' to exercise the option at the time of the step-up, if what the issuer holds truly is an option then it could not be said that the issuer had an effectively noncontingent obligation to do so. 5.2 Reclassify In addition, if the convertible notes were to satisfy the debt test in the period up to the time that the issuer could exercise the option (ie, from 2011), it is unclear which provision would be operative to 'reclassify' the notes as equity from that time. One view would be that the notes effectively default to equity interests under section (1)(e), on the basis that there would no longer be a debt interest on issue. The other view would be that there is a reclassification on the basis that there is a material change to the scheme. According to section : (a) (b) where a scheme gives rise to a debt interest (or an equity interest) in a company and; the scheme subsequently changes, resulting in an equity interest (or a debt interest) in the company coming into existence after the change; Division 974 will apply after the change as if the scheme, as it existed immediately after the change, came into existence when the change occurred. If one considers the view adopted in the Draft Taxation Determination in light of section , you would have to say that the Commissioner's view depends on the conclusion that the material change occurs at the time when the option crystallises, rather than the time when the convertible notes were actually converted into the ordinary shares. If this is so, you would have to query whether the Commissioner's interpretation would objectively be regarded by a court as the better view as it is questionable whether, in fact, there has been a material change. In light of the above, it will be interesting to see whether the Commissioner's view adopted in the Draft Taxation Determination is ultimately maintained. We understand that the Draft Taxation Determination is to be converted into a tax ruling so that a more detailed analysis of the Commissioner's view and any alternative view is provided. A further related issue will be whether the tax ruling will have retrospective application as the view currently adopted by the Commissioner in the Draft Taxation Determination is seen to represent an interpretation that is inconsistent with previously stated views on this issue (see Example mafm M v Page 17

18 2.26 contained in the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Act 2001). 6. Solvency Clauses Another issue relating to the meaning of effectively non-contingent obligation for the purposes of section is the effect of 'solvency clauses'. A 'solvency clause' is essentially a provision contained in certain debt documentation which sets out what happens when the debtor is unable to pay the creditor. Solvency clauses can be drafted in different ways. However, regardless of its form, the effect and substance of such clauses is generally the same. That is, the debtor/issuer will not, in broad terms, be required to make the relevant payments while the debtor/issuer is insolvent. Up until the end of last month, the ATO and Treasury had expressed the view that, in some cases, the existence of a particular type of solvency clause may mean that the debtor/issuer does not have an effectively non-contingent obligation to provide a financial benefit on the basis that the issuer's obligation is contingent upon its solvency. According to the National Tax Liaison Group Finance and Investment Sub-Committee Minutes of Meeting 26, this issue first came to light after the Government announced in March 2003 that income tax regulations would be made to clarify the operation of debt/equity rules for certain Upper Tier 2 instruments issued Authorised Deposit-Taking Institutions (ADIs) 27. In the course of developing those regulations, Treasury examined certain solvency clauses found in Upper Tier 2 and Lower Tier 2 instruments. Treasury identified two types of solvency clauses. The first type was a clause which provides that where the obligation could not be met, the issuer would become insolvent. The second type provides that, if the obligation to make the payment were required to be met and it would put the issuer into insolvency, the obligation to make the payment would not have to be met until such time that the condition no longer applied. It was the second type of clause that created the problems. In particular, the view was expressed by the ATO and Treasury that the obligation to make a payment could be seen as being contingent on the continuing solvency of the issuer and, therefore, contingent on the economic performance of the entity having the obligation. If this view were adopted, subordinated debt instruments containing these solvency clauses would have failed to satisfy the debt test in Division 974, despite the fact that these instruments have been commonly understood to be debt. This would have had serious 26 see National Tax Liaison Group Finance and Investment Sub-Committee Minutes of Meeting of 11 August 2004, 3 February 2005 and 8 August ADIs such as banks and building societies are required to keep a certain percentage of capital against their risk weighted assets. Capital is divided into three layers: Tier 1 which is pure equity (such as ordinary shares, non-redeemable preference shares and certain hybrids), Upper Tier 2 which includes perpetual subordinated debt and Lower Tier 2 which includes fixed subordinated debt. These requirements are set out in Prudential Statements issued by the Australian Prudential Regulation Authority (APRA). They are also the subject of a lucid discussion in Hill J's judgment in Macquarie Finance Limited v Commissioner of Taxation 2004 ATC mafm M v Page 18

19 ramifications for the issuers of these instruments as, amongst other things, they would have been unable claim deductions on the interest payments. Fortunately, Treasury and the ATO now seem to have backed away from this view with the announcement by the Minister For Revenue and the Assistant Treasurer on 25 October 2005 that the Government would make new income tax regulations to ensure that 'solvency clauses' do not preclude certain subordinated notes from being treated as debt for tax purposes (Press Release No. 90 of 2005). Significantly, the press release states that, while these solvency clauses are commonly found in Lower Tier 2 term subordinated notes issued by ADIs, the regulations will apply to all issuers. No indication is given in the press release as to when the regulations will be issued. However, it is stated that the regulations will be developed in consultation with key stakeholders. There can be little doubt that the position adopted by the Government in the 25 October press release represents the correct view. An obligation will be considered non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation (sub-section (3)). In the circumstances where an obligation to make a payment is dependent on the solvency of the debtor, it is clear that the only relevant event, condition or situation affecting this will be the debtor's ability to pay. This is reinforced by section 95A of the Corporations Act 2001, which states that a person is solvent if, and only if, the person is able to pay all the person's debts, as and when they become due and payable. Accordingly, it can be said that where an issuer's obligation to make a payment is made contractually contingent on its solvency, the issuer's obligation to pay should remain non-contingent for the purposes of sub-section (3) as the only event, condition or situation affecting the issuer is its ability to meet the relevant obligation. In addition, in determining whether there is in substance or effect a non-contingent obligation, sub-section (6) provides that it is necessary to have regard to the artificiality or the contrived nature of any contingency on which the obligation to take the action depends. According to paragraphs and of the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Act 2001): where a contingency is so remote as to be effectively inoperative (immaterially remote), it is as if the contingency did not exist and should be disregarded. In some circumstances it will be clear that a particular contingency is immaterially remote for these purposes. These will be cases where there is only a theoretical rather than a real possibility of the contingency occurring. Given that the debt and equity tests are to be applied at the time the relevant interest comes into existence (and therefore, it is at that time that it is necessary to consider the likelihood of any contingency occurring), it may be said that, where a financial institution or corporate issues a debt instrument, the likelihood of that issuer becoming insolvent, will, in most circumstances, be only a theoretical possibility and therefore, should be disregarded for the purpose of section mafm M v Page 19

20 The final point to note is that, even if an issuer does becomes insolvent, it does not necessarily mean that the issuer's obligation to make the relevant payments will not be performed. Rather, the obligations of the issuer may be deferred until such time as the issuer is in a position to satisfy the obligations. The deferral of the issuer's obligations in the event of insolvency is a common feature of the Upper Tier 2 and Lower Tier 2 subordinated debt instruments Treasury examined. In addition, it must be remembered that if the issuer is wound up, the holders of the relevant instrument will have the right to claim for amounts outstanding ahead of equity holders but behind more senior creditors. Therefore, in the circumstances where an issuer does become insolvent, the likelihood of an issuer not being able to fulfil its obligations must really be considered on a case by case basis. 7. Section Section provides an additional equity test. That is, the primary equity test is set out in section However, in addition to the arrangements covered by section , an arrangement will be classified as equity if it satisfies the criteria of section Conceptual In conceptual terms, the purpose of the equity test in section is to cause a nonequity interest to be classified as equity if the non-equity interest is held by a connected entity of the issuer, and the non-equity interest funds an equity-like return to a third person (that is, a return which has the hallmarks of equity under the primary equity test). In colloquial terms, section is directed at arrangements under which a 'debt piece' is issued to a connected entity and is used to fund an 'equity piece' held by a third person. The effect of section is to cause the debt piece to be classified as equity. Hence, section can be viewed as a response to a concern on the part of the revenue that, by simply inserting an entity in between an issuer and an investor, companies could achieve an outcome whereby the issuer obtains the tax benefits of issuing debt in relation to a financing arrangement which, when viewed in its entirety, is equity in nature. Issuer debt Connected entity equity Investor However, in the broader context, it is not clear why the tax laws should operate to recharacterise the debt piece as equity in these circumstances. In the absence of contrivance, why should it be a concern for revenue authorities if parties choose equity funding at one level and debt funding at another level of an overall commercial transaction, particularly if the overall transaction is contained within the Australian tax system? 7.2 Limbs of Section In broad terms the limbs of section are as follows: mafm M v Page 20