The good news is the Government has finally released a draft of the rules which will repeal the much-maligned s.974-80. The bad news is that the replacement is a disappointing melange of indecisive text that could well cause as much heartache as the provision being replaced, at least until a new body of industry ‘lore’ emerges. It seems clear that the new rule will be wider in its scope than the old rule, and will change the circumstances in which instruments might be aggregated. This Tax Brief examines the good, the bad and the decidedly curious in the draft legislation.
1. A BIT OF HISTORY
One of the most contentious provisions in the debt-equity rules is s.974-80, which treats a debt instrument as equity (making the interest payment non-deductible and the receipt potentially a dividend) if the interest paid on the instrument funds the return on an equity instrument. The proper scope and application of the rule was anything but clear, but its consequences were potentially disastrous.
It is not apparent whether the section had often been wielded in anger by the ATO since the start of the debt-equity rules, but when the ATO announced it would start examining payments between stapled entities in the property and infrastructure sectors for compliance with s.974-80, the problems with the provision became very pressing. Nothing in the history or design of s.974-80 suggested it was meant for cross-staple payments, but on its face the possible application was at least arguable. The ATO published a discussion paper on s.974-80 in 2007 which was greeted with some dismay by industry.
In the May 2011 Budget the Labor Government announced that s.974-80 would be amended to ensure it would only apply ‘where both the purpose and effect is that the ultimate investor has, in substance, an equity interest in the issuer company,’ but industry quickly concluded that the government’s announced approach was not particularly different from the current law, and the proposal foundered. In 2012 the ATO, perhaps in an attempt to placate some disquiet, published a draft Tax Ruling on when s.974-80 might apply to cross-staple loans, but the Ruling was never finalised and was withdrawn in 2013.
In the May 2013 Budget the Government tried again – it commissioned the Board of Taxation to undertake a general review of the entire debt-equity regime which had been in operation for more than a decade at that time. This project survived the December 2013 cull by the incoming Government of announced but unenacted measures. In the meantime, the ATO issued three Tax Determinations in 2015 which went some way to pacifying the ongoing disquiet.
In December 2014, the Board sent to the Government an ‘accelerated’ report recommending the repeal of s.974-80. The Board also recommended changes to the much less contentious ‘related scheme’ rules (which can aggregate instruments and treat them as effectively a single scheme) on the basis that both sets of rules dealt with the same issue. In essence, both provisions would be repealed but they would be replaced with a single new provision.
While this consolidation seems appealing at first glance, there must be some doubt whether the issue is as straight-forward as that. There are three kinds of situations where these rules are in play:
- sequential arrangements (which is the province of s.974-80): the interest on Loan 1 funds the return on Instrument 2 which funds the return on Instrument 3, etc;
- cross-staple payments (which the ATO argued was also within s.974-80): for example, the interest from Company 1 forms part of the net income of Trust 1; and
- parallel arrangements (which used to be described as ‘related schemes’): the financial relationship between just two parties is constructed from the combined effect of Instrument 1 and Instrument 2.
Separate rules existed because they dealt with slightly different situations: s.974-80 was an ‘integrity rule’ designed to attack sequential arrangements and those kinds of arrangements did not fit easily into the definition of ‘related schemes.’
Nevertheless, the Government approved and released the Board’s ‘accelerated’ report in April 2015 indicating that it would consult on draft legislation. The Exposure Draft legislation (‘the ED’) was released for consultation on 10 October 2016.
2. THE NEW PROVISIONS
Aggregation. The new provisions in the ED offer a single rule for all three situations just described: sequential arrangements, cross-staple payments and parallel arrangements. Under the new approach, multiple instruments will be treated as ‘a single aggregate scheme’ for the purposes of the debt-equity rules where three conditions are met:
- the pricing, terms and conditions of the instruments are inter-dependent or linked, or the pricing, terms and conditions of one instrument change the economic consequences of another instrument;
- the individual instruments were designed to operate together and produce the combined economic effect; and
- if the instruments were characterised in isolation, the character of one or more of the instruments would be different.
Safe harbours. The ED also contains four indicative safe harbours: the instruments are not linked or inter-dependent ‘merely because’:
- the return on one instrument funds the return on another unless that is part of the terms of the structure (a position which the ATO accepted under current law in a 2015 Tax Determination);
- the interests are stapled;
- the obligation to pay a return on one instrument is subordinated to meeting the obligation to pay a return on another; or
- one interest is subjected to a security interest in order to secure the return on another.
Consequences. Where two or more instruments are aggregated the next question is, what happens now? The rule drafted to answer that question does not give straightforward answers.
Indeed, there is nothing in the ED to answer the ‘so what now …’ question. The rules just outlined treat aggregated instruments as creating a single scheme but they do not say whether that scheme is equity or debt. This is the crucial step in applying the test and the text has nothing to say on it. The assumption seems to be that one can simply apply the current debt and equity definitions to a scheme consisting of multiple instruments in a meaningful way without further legislative guidance.
We will discuss the Examples accompanying the ED below, but it is instructive that none of the Examples tries to tease out in detail what happens (for the few Examples) when discrete instruments are aggregated. One Example involves (i) shares in a company, (ii) stapled to units in a trust, (iii) a loan to the company from the trust and (iv) another loan to the company from external financiers. The analysis focuses almost entirely on which combination of instruments can be aggregated, and concludes that the shares, the units and the internal loan are to be aggregated. A brief comment says the consequence is that the loan from the trust is no longer a debt interest.
This seems the obvious result that the drafters would want to happen but the application of the definitions is not self-evident, especially when applied to sequential instruments. It requires a single conclusion to be drawn about the character of the single scheme which emerges from these aggregated documents. And just why the equity features of the arrangement necessarily trump the debt characteristics of the loan is not analysed. Indeed, this is the basic problem of the Examples – whether instruments are aggregated or not depends upon judgments about how much weight to give to individual factors; the analysis of each Example says very little about why factor 1 was critical but factor 2 was not.
3. SOME COMMENTS
The provision is grappling with the issue, under what circumstances should two or more instruments be treated as one? Rather than settle on a definitive answer, the ED basically says, ‘it depends …’, which does not advance the matter much.
This is not new territory. The same issue arises under the TOFA rules and the indecisive answer given in the current ED is largely modelled on the TOFA approach. In the TOFA rules, the decision whether multiple instruments create a single ‘financial arrangement’ is tested ‘having regard to …’ a variety of factors; and in the ED, the instruments are analysed ‘having regard to …’ a list of factors. And the factors in each list look more than a little similar; in both lists, we are told to have regard to ‘normal commercial understandings and practices …’ and the circumstances surrounding their creation. The ATO has issued a 42-page Ruling on how this section works for the TOFA rules; no doubt a similar Ruling will emerge for the purposes of this provision in the debt-equity rules.
However, it is important to note that in the ED we are meant to be looking at these factors with a particular goal in mind – to find evidence of ‘design …’ – and so some factors such as whether the same parties are involved in both instruments and the relationships between the parties are likely to be very influential in the new law.
Not only is the ED deliberately indecisive, the new drafting perpetuates existing problems because it reproduces portions of the existing text – for example, the current text refers to, ‘a scheme, or a series of schemes, designed to operate’ in a particular way; the text in the ED requires a finding that ‘the schemes were designed to operate together …’.
And as for the safe harbours, they are helpful but they are not definitive. The drafting makes it clear that the instruments will not be aggregated if this is the only feature which suggests aggregation. The problem is, there will almost always be other features in play.
Other features of the new drafting are more worrying. The meaning of s.974-80 may have been doubtful but its operation was limited by a number of precise conditions: only an instrument issued by a ‘company’ could be affected, that instrument had to be issued to a ‘connected entity’ and the return which the ultimate recipient would enjoy needed to be traced back to the company. The new provision does not have these limits: it can aggregate instruments issued by anyone and issued to anyone. This is confirmed by a new provision in the ED which will deny any entity (not just a company) a deduction for interest on an instrument that has been aggregated and treated as an equity instrument. Section 974-80 may have been repealed but its successor has been let out of the cage.
It may be that what is presented as three tests will in reality prove to be just one – the inter-connected test. In practice, it is possible the ATO will intuitively adopt the approach that linkage equals design. We will discuss the Examples below but it is instructive that in all of the Examples if the inter-dependence test is met, so too is the design test, and if the inter-dependence test is not met, neither is the design test (or it is simply ignored).
Adopting such an approach would be sensible – an appropriate degree of inter-dependence should not be triggered by accident or oversight. But this rosy vision runs into the problem that ‘design’ is not meant to be a subjective matter. Rather, just as in Part IVA, what the parties actually had in mind is meant to be irrelevant; what matters is whether someone would conclude from the listed factors that there was design. This form of words deliberately creates the possibility that design can be found just because the parties were related or the instruments were negotiated at the same time or some other matter.
The Examples are also uninformative about one of the more imponderable aspects of the inter-dependence element. Instruments can be aggregated if the pricing, terms and conditions of two instruments are ‘dependent or linked.’ Presumably this is something visible by examining the drafting of the 2 instruments. But aggregation can also occur where one instrument ‘changes the economic consequences of’ another instrument. The Examples which rule that aggregation must occur do not differentiate whether that is because the instruments are ‘dependent or linked’ or because one instrument ‘changes the economic consequences of’ the other. We have no useful guidance into just how or when one instrument changes the ‘economic consequences’ of another.
Finally, we can’t resist noting the draft Explanatory Memorandum which accompanies the ED contains the self-serving assertions we are all familiar with: that the debt-equity rules ‘ensure that interests arising from schemes are correctly classified … according to their economic substance’; the newly-amended debt-equity tests will now ‘accurately reflect reality’ and, what is more, the new provisions ‘will reduce compliance costs’ compared to the current law. None of this is true of the current law, and the Examples all but give the lie to the idea that, from now on, instruments will be classified ‘according to their economic substance’ because of the ED. It is striking just how many of the Examples find evidence of linkage if documents refer to each other, and no evidence of linkage if they don’t. (The obvious lesson is to draft sparingly!) And we are willing to hazard a guess that compliance costs will increase in the short term pending a new body of industry ‘lore’ about just what these provisions mean, and in the long term they will fall back to a new equilibrium that is at least as expensive as the current rules.
4. THE EXAMPLES
The most curious aspect of the project is the decision to support the text of the ED with a number of Examples, which will be given quasi-statutory effect by entrenching them in a legislative instrument. This approach had been recommended by the Board. It is a novel way of trying to give taxpayers some certainty in the face of an indecisive statute but it is unchartered territory – using Examples in legislative instruments is not a common legislative practice.
The ED says the Examples ‘may extend or narrow the operation’ of the legislation, so they could prove more robust than the legislation itself. But the obvious question is just how closely does reality have to match the Examples? Are the Examples meant to be understood as:
- precise instances where the rules are deemed to produce this outcome (whether the rules would otherwise produce this outcome or not); or
- representative of a broader class of situation with similar but not identical features?
Because this is a new adventure in legislating, it is not clear just what a Court would make of the Examples. The Acts Interpretation Act says simply that examples in an Act are not exhaustive, and the ED says the Examples don’t have to be consistent with the Act. But that is a long way short of legislating what the Board had hoped: that the Examples would outline principles and those principles could be extrapolated to similar situations and the principles would then inform the reading of the legislation for similar situations. It may be that some effort has to go into giving a robust legislative basis to back up the Board’s aspirations.
Which facts matter? In the very first Example, a shareholder subscribes $100,000 for shares and ‘at the same time’ lends $150,000 to the company. Neither the subscription agreement nor the loan agreement refer to each other. The unsurprising result is that these two instruments are not to be aggregated.
But what happens if the facts vary? Presumably it cannot be critical to the outcome that the amount of equity is $100,000 and the debt $150,000. And for this Example, the text says that if the ratios between the equity and debt were different, the ‘aggregation rule would still not apply …’, implying that the gross amounts should not matter either. (Unhappily, few of the Examples include variations to the facts that are declared to be irrelevant on the one hand, or critical on the other.)
But is it meant to be relevant that the share subscription and the loan occur ‘at the same time’? And would the result still occur if the documents did refer to each other, but the dividends and interest are calculated in the usual way? Neither of these matters is mentioned in the lists of irrelevant (or critical) variations.
Which reasons matter? The Example takes the view that the shares and loan are not aggregated ‘because the company must perform its obligations under the loan agreement regardless of the pricing, terms and conditions attached to the issuing of the shares’ and ‘nothing about the shares affects … anything … about the loan’. That is true on the facts of the Example, but one is left wondering about what to do if there are other reasons for not aggregating. For example, if the terms of the share issue and loan instrument were linked, would the two instruments be aggregated or would they remain disaggregated because ‘normal commercial understandings and practices’ do not treat a shareholder’s shares and loans as a single thing?
The second Example raises this issue very clearly. The structure is a sequence of instruments with interest paid by a company to a second company which then pays a dividend to its shareholders. This is territory where s.974-80 might prove problematic. Broadly, the ATO has accepted the view that if the income of the second company is supplemented by other amounts, the current law does not apply; the supplementary income breaks the link between the interest received and the dividend paid. The Example says that the new rule would not apply either, but now it is because the terms of the loan do not refer to the terms on which dividends will be paid. Again the obvious question is, if the terms of the loan and the share issue did refer to each other, would the taxpayer be able to rely on the current reason instead – the interest income is being supplemented by other income earned by the paying company.
Objectively determined design. We noted above that in all of the Examples if the inter-dependence test is met, so too is the design test, and if the inter-dependence test is not met, neither is the design test (or else it is simply ignored). This has the unhappy consequence that the Examples have almost nothing to say about the design test.
5. SOME OTHER MATTERS IN THE ED
Amendments to the thin capitalisation test for hedging instruments. The ED contains one consequential change to undo the implications for the thin capitalisation rules of aggregating two or more instruments under the new test.
The new provision will apply when a hedging instrument is aggregated with another instrument which is debt. When that condition is met, the hedging instrument is disaggregated again but just for the purposes of the thin capitalisation rules. The intended effect is that the losses on the hedging instrument are not potentially disallowed just because they now form part of a composite debt interest. This curious provision may represent a significant change to current law; it certainly warrants further consideration. Interestingly, the Explanatory Memorandum has nothing to say about it.
Making the new provisions fit. The ED makes some minor adjustments to the current law so that the new provisions will fit more easily into the legislative structure:
- the preface to the debt test and the equity test are modified to make it clear that the tests are applied to the single scheme created from the aggregated instruments;
- the rules which are enlivened when there is a material variation to an existing instrument, a new subsequent instrument is added to an existing arrangement or part of an existing scheme is cancelled are modified to accommodate the new provisions; and
- there are some minor changes to the text of the disaggregation rule – the provision which allows the ATO to turn a single scheme into several schemes.
These changes are largely cosmetic rather than substantive.
6. COMMENCEMENT AND TRANSITION
It is proposed that the new measures will only apply to transactions which are entered into after a date to be proclaimed (or 6 months after the Bill is enacted if no date is proclaimed for this purpose). Instruments which are on foot at that time will apparently not be affected although there must be a possibility that the new provisions will be drafted so that they would be attracted if a material variation is made to an existing instrument.
Interestingly, because an amendment had been promised in the May 2011 Budget, and the Coalition parties promised in December 2013 to continue work on that proposal, the Government is proposing to add this item to the list of ‘announced but unenacted measures’. Where a taxpayer has taken a position in the past in reliance on an announcement which is on the list, the taxpayer is protected from the ATO issuing an amended assessment. This provision would be of use to any taxpayers who took the rather ambitious view that the 2011 Budget announcement promised the relaxation of s.974-80, and so did not apply s.974-80 to their debt instrument. That stance is protected for past years, and the protection of their instrument will survive the enactment of the new rules.
7. WHAT NEXT?
The ED is open for comment until Monday 21 November.
Which leaves the unfinished business of the Board’s main report. Further amendments will be needed to the debt-equity rules to enact the recommendations it made but we have no date for the release of that legislation. It may also be the case that some of the Recommendations in that report – and the legislation to implement them – will now need to be revised because of the changes being made by the ED and the way the ED has gone about achieving its intended effects.