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INCOME TAX ASSESSMENT AMENDMENT REGULATIONS 2010 (NO. 3) (SLI NO 73 OF 2010)
Select Legislative Instrument 2010 No. 73
Income Tax Assessment Act 1997
Income Tax Assessment Amendment Regulations 2010 (No. 3)
Section 909-1 of the Income Tax Assessment Act 1997 (the Act) provides, in part, that the Governor-General may make Regulations prescribing matters required or permitted by the Act to be prescribed, or which are necessary or convenient to be prescribed for carrying out or giving effect to the Act.
The Regulations amend the Income Tax Assessment Regulations 1997 to ensure comparability between Australia’s tax rules and those of other jurisdictions.
Effective generally from 1 July 2001, the New Business Tax System (Debt and Equity) Act 2001 amended the Act by introducing a new Division 974 which contains rules to distinguish between debt and equity for various income tax purposes. One of the important implications of the debt / equity distinction in Division 974 of the Act is that returns on debt interests may be deductible but are not frankable. Returns on equity interests may be frankable but are not deductible.
Broadly, Division 974 focuses on a single organising principle in making the distinction between debt and equity: whether, in substance, an issuer has a non-contingent obligation to repay the investment. An obligation that meets this basic test is referred to as an ‘effectively non-contingent obligation’ to repay the investment.
Section 974-135 of the Act sets out what, in a technical sense, constitutes an effectively non‑contingent obligation. To be a non-contingent obligation, the obligation must not depend on any event, condition or circumstance, including the economic performance of the entity with the obligation. There is an effectively non-contingent obligation to take an action if, having regard to the pricing, terms and conditions of the relevant scheme, the obligation is in substance or effect a non-contingent obligation to take that action.
Paragraphs 974‑135(8)(a) and (b) of the Act provide that regulations may make further provisions relating to what constitutes and what does not constitute a non-contingent obligation for the purposes of section 974-135 of the Act.
The purpose of the Regulations is to facilitate debt tax treatment of certain term subordinated notes. Under the notes, payment can be deferred in certain circumstances and holders are only entitled to payment after other debt holders have been paid. These notes are used to contribute to the capital adequacy of Authorised Deposit-taking Institutions (ADIs) for the purposes of prudential regulations. However, the Regulations apply to all issuers.
The Regulations provide that an obligation to pay the principal or interest on the relevant note is not precluded from being a non-contingent obligation (and the note is not precluded from being a debt interest) by certain solvency and capital adequacy clauses in the notes. The solvency and capital adequacy clauses are commonly found in term subordinated notes issued by ADIs. They allow or require that the payment of the principal or interest be deferred in certain circumstances. Without
the Regulations, these clauses may make the obligation a contingent obligation, as the obligation would be contingent on the solvency or capital adequacy of the entity.
While facilitating the debt treatment of these notes, the Regulations do not of themselves deem such notes to be debt interests or make returns on the notes tax deductible.
Details of the Regulations are set out in the Attachment.
The Regulations commence on 15 April 2010, and apply to obligations to pay the principal or interest on a relevant term subordinated note on or after 1 July 2001.
Subsection 12(2) of the Legislative Instruments Act 2003 prevents the retrospective operation of regulations which adversely affect the rights of a person, or impose liabilities on a person, in respect of anything done or omitted to be done before the date of registration. In this regard, in the following circumstances the Regulations will not apply to a payment of the principal or interest on a relevant term subordinated note before 15 April 2010. The Regulations will not apply if the application results in the rights of a person as at 15 April 2010 being affected so as to disadvantage that person, or in liabilities being imposed on a person, in respect of anything done or omitted to be done before 15 April 2010.
Draft Regulations were released on 22 April 2009 for public consultation, and submissions closed on 22 May 2009. The Regulations take into account the submissions as well as subsequent consultations.
The Regulations are a legislative instrument for the purposes of the Legislative Instruments Act 2003.
The Act specifies no conditions that need to be satisfied before the power to make the Regulations may be exercised.
Details of Income Tax Assessment Amendment Regulations 2010 (No. 3)
Regulation 1 – Name of Regulations
This regulation provides that the title of the Regulations is the Income Tax Assessment Amendment Regulations 2010 (No. 3).
Regulation 2 - Commencement
This regulation provides that the Regulations commence on 15 April 2010.
Regulation 3 – Amendment of Income Tax Assessment Regulations 1997
This regulation provides that the Income Tax Assessment Regulations 1997 (the Principal Regulations) are amended as set out in Schedule 1.
Schedule 1 – Amendments
Item 1 inserts a new Regulation 974-135D (regulation) in Subdivision 974-D of the Principal Regulations.
Subregulation 974-135D(1) sets out that the regulation applies to obligations to pay the principal or interest on a relevant term subordinated note on or after 1 July 2001.
Subregulation 974-135D(2) is the primary operative provision. It provides that an obligation to pay the principal or interest on a relevant term subordinated note is not precluded from being a non‑contingent obligation because of certain solvency or capital adequacy conditions in the note. These solvency or capital adequacy conditions allow the payment of the principal or interest to be deferred under certain circumstances. Without the regulation, these conditions may cause the obligation to be considered to be contingent and may preclude the note from being a debt interest.
Subregulation 974-135D(3) sets out the features of a relevant term subordinated note to which the regulation applies.
Subregulation 974-135D(4) sets out what insolvency or capital adequacy conditions means for the purpose of the regulation.
Subregulation 974-135D(5) provides a definition of insolvent for the purposes of the regulation.
Subregulation 974-135D(6) puts beyond doubt that the regulation does not apply to the extent that there is negative retrospective impact on affected taxpayers.
Subregulation 974-135D(1) provides that the regulation applies to an obligation to pay the principal or interest on a relevant term subordinated note on or after 1 July 2001.
Subregulation 974-135D(4) sets out the conditions which require or allow the payment of the principal or interest to be deferred.
These conditions are:
• the issuer of the note is obliged or able to defer the payment of the principal or interest beyond the date on which it would otherwise be payable if, immediately before payment, the issuer is insolvent; or
• the issuer of the note is obliged or able to defer the payment of the principal or interest beyond the date on which it would otherwise be payable if, immediately after payment, the issuer would be insolvent; or
• if the issuer of the note is an entity that is regulated by the Australian Prudential Regulation Authority (APRA) or a comparable foreign regulator, the issuer is obliged or able to defer the payment of the principal or interest beyond the date on which it would otherwise be payable if:
– immediately before payment, the issuer is in breach of its capital adequacy ratio as set out in the prudential standards that deal with capital adequacy; or
– immediately after payment, the issuer would be in breach of its capital adequacy ratio as set out in those standards.
The insolvency or capital adequacy conditions are consistent with prudential standards which, for Australian purposes, are standards made by APRA under section 11AF of the Banking Act 1959.
But for these conditions, the terms of the note would ordinarily be that payment of principal or interest (or both) cannot be deferred. That is, there would be an obligation to make payment on the payable date if none of the insolvency or capital adequacy conditions applied on that date.
For the purposes of this regulation a foreign regulator will not be a comparable foreign regulator unless it issues and administers prudential standards that, in material respects, are substantially similar to those made and administered by APRA.
A term subordinated note is a financial instrument generally used by companies to obtain finance. It has the following features:
• a fixed term by the end of which the note must be repaid; and
• payment is subordinated to the interests of more senior creditors.
Term subordinated notes that are subject to the regulation must have the following features:
The term subordinated notes would ordinarily qualify as Lower Tier 2 capital for prudential purposes if an Authorised Deposit-taking Institution issued them.
At the time of issuance, the note must not constitute, or meet the requirements of, a Tier 1 capital instrument.
A term subordinated note may have the characteristics of a Tier 1 capital instrument but not be classified as such for prudential purposes because the entity, or a connected entity, has an excess of Tier 1 capital. If this is the reason that the note does not form part of Tier 1 capital of the issuer, it will not come within the terms of the regulation.
Tier 1 capital is a type of capital classified by APRA for the purposes of prudential regulation. The limitation in relation to Tier 1 capital is of no relevance for entities that are not subject to prudential regulation.
The note must have a term of 30 years or less and there must be no unconditional right to extend the term of the note beyond a total term of 30 years.
The note must contain a condition that any deferred payments must accumulate until such time as the payment is made. The deferred payments do not have to compound which means, for example, that interest does not have to be paid on any deferred payment of interest.
Under the terms and conditions of the note, the issuer of the note must not have an unconditional right to decline to provide a financial benefit that is equal, in nominal value, to the issue price of the note to settle the obligations under the note. The limitation reflects the concept of a liability for financial accounting purposes; accordingly, the limitation is designed to ensure that the regulation does not facilitate debt tax treatment for a note that is not a liability for financial accounting purposes.
For the purpose of this regulation, an issuer is considered to be insolvent where either:
• the issuer cannot pay its debts as they fall due; or
• the issuer’s liabilities exceed its assets.
If the issuer meets either of these definitions, it is insolvent for the purposes of the regulation.
As discussed above, the regulation applies to obligations to make payments of the principal or interest on a relevant term subordinated note on or after 1 July 2001.
As this application date is prior to the date of registration of the regulation, there may be a potential for negative retrospective application of the regulation which may result in the regulation being of no effect under subsection 12(2) of the Legislative Instruments Act 2003.
Subregulation 974-135D(6) provides that the regulation applies only to the extent that there is no negative retrospective application from 15 April 2010 which is the date of registration. This is to make clear that the regulation will remain valid except for any negative retrospective application.
The following conditions are set out in subregulation 974-135D(6) in order for subregulation 974‑135D(2), the main operative subregulation, to apply in relation to obligations to make payments of principal or interest on or before 15 April 2010:
• the rights of a person, other than the Commonwealth or an authority of the Commonwealth, would not be affected so as to disadvantage that person as a result of the application of the regulation to the obligation to pay the principal or interest; or
• liabilities would not be imposed on a person, other than the Commonwealth or an authority of the Commonwealth, in respect of anything done or omitted to be done by that person before 15 April 2010 as a result of the application of the regulation to the obligation to pay the principal or interest.
If the conditions outlined above are not met, the regulation is ineffective only with respect to the particular obligation in question, rather than being ineffective with respect to its retrospective application to other eligible obligations.
This regulation does not have the effect of deeming an instrument to be a debt interest where it would otherwise have been an equity interest.
It only provides, for the purposes of section 974-135 of the Act, that certain obligations are not prevented from being non-contingent obligations as a result of the insolvency or capital adequacy conditions in a note that allows or requires the issuer to defer the timing of discharge of the obligations. In order for a note to be classified as a debt interest it will still need to satisfy the debt test in subsection 974‑20(1) of the Act. Further, the regulation does not of itself provide that returns on eligible notes are deductible for tax purposes.
The regulation also does not override any need to consider whether a note to which this regulation applies is itself part of a related scheme. This can be relevant for the purposes of determining whether the note and a related scheme taken together satisfy the debt test or the equity test.
Example 1
An entity has an obligation to pay interest on a note to which this regulation would apply.
The effect of the regulation applying is that certain contingencies in relation to these obligations are disregarded for the purposes of determining whether the entity has an effectively non-contingent obligation to make those payments.
As a result of the regulation applying, the scheme that is the note considered in isolation may be a debt interest for the purposes of Division 974 of the Act.
However, the note is itself part of a related scheme. There is nothing in the regulation that prevents the two schemes, constituted by the note and its related scheme, from being an equity interest for the purposes of, for example, subsection 974-70(2) of the Act.