Commonwealth Numbered Regulations - Explanatory Statements

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INCOME TAX ASSESSMENT AMENDMENT REGULATIONS 2011 (NO. 2) (SLI NO 35 OF 2011)

Explanatory Statement

Select Legislative Instrument No. 35

[Issued by authority of the Assistant Treasurer]

Income Tax Assessment Act 1997

Income Tax Assessment Amendment Regulations 2011 (No. 2)

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 remove existing uncertainty concerning the tax treatment of certain hybrid capital instruments.

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, there 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 perpetual subordinated notes.  The notes have no fixed term and the holders of the notes rank behind all creditors (except those creditors expressed to rank equally with or behind the holders of the notes) but ahead of ordinary shareholders and preference shareholders upon liquidation. These notes are used to contribute to the capital adequacy of Authorised Deposit-taking Institutions (ADIs) for the purposes of prudential regulations.

The Regulations apply to entities that are regulated for prudential purposes by the Australian Prudential Regulation Authority (APRA).  The Regulations also apply to entities which are regulated by a comparable foreign prudential regulator under comparable capital adequacy requirements.  Generally these entities are ADIs, foreign ADIs and their subsidiaries.

The Regulations provide that an obligation to pay interest on the relevant note is not precluded from being a non-contingent obligation (with the effect that the note is not precluded from being a debt interest) by certain profitability, insolvency or negative earnings conditions in the notes.  These conditions are commonly found in perpetual subordinated notes issued by ADIs.  They allow or oblige the issuer of those notes to defer the payment of interest on the notes in certain circumstances.  Without the Regulations, these conditions may make the obligation a contingent obligation, as the obligation would be contingent on the profitability, insolvency or negative earnings status of the issuer. 

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 the day after they are registered on the Federal Register of Legislative Instruments, and they apply to obligations to pay interest on a relevant perpetual 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 do not apply to a payment of interest on a relevant perpetual subordinated note before the commencement of the Regulations.  The Regulations do not apply if their application results in the rights of a person, immediately before the commencement of the Regulations, 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 the commencement of the Regulations.

There have been several targeted confidential consultations with the banking industry on draft Regulations during 2008 to 2010.  The Regulations take into account the submissions and issues raised during the 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.

Attachment

Details of the Income Tax Assessment Amendment Regulations 2011 (No. 2)

Regulation 1 - Name of Regulations

This regulation provides that the title of the Regulations is the Income Tax Assessment Amendment Regulations 2011 (No. 2).

Regulation 2 - Commencement

This regulation provides that the Regulations commence on the day after they are registered.

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] - Subregulations 974-135D(3) and (4)

Item 1 updates the language used in subregulations 974-135D(3) and (4).  For a provision that sets out the meaning of a defined term, the preferred language is 'In this regulation...', rather than 'For this regulation...'.

[Item 2] - Subregulation 974-135D(5)

Item 2 deletes subregulation 974-135D(5), which included the definition of insolvent.  The definition is moved to Division 995 (Definitions) of the Principal Regulations by Item 5 below.

[Item 3] - Subregulation 974-135D(6)

Item 3 renumbers previous subregulation 974-135D(6) as subregulation 974-135D(5).

[Item 4] - Regulation 974-135E

Item 4 inserts a new regulation 974-135E into Subdivision 974-F of the Principal Regulations. 

Regulation 974-135E provides that certain conditions on the obligation to pay interest on certain perpetual subordinated notes do not of themselves prevent the obligation from being a non-contingent obligation for the purpose of the debt test in the Act.

Structure of the regulation

Subregulation 974-135E(1) sets out that regulation 974-135E applies to obligations to pay interest on a relevant perpetual subordinated note on or after 1 July 2001.

Subregulation 974-135E(2) is the primary operative provision.  It provides that an obligation to pay interest on a relevant perpetual subordinated note is not precluded from being a non-contingent obligation merely because of certain profitability, insolvency or negative earnings conditions on the obligation.  These profitability, insolvency or negative earnings conditions allow or oblige the payment of interest to be deferred under certain circumstances. Without regulation 974-135E, these conditions may cause the obligation to be considered to be contingent and may preclude the note from being a debt interest. 

Subregulation 974-135E(3) sets out the features of a relevant perpetual subordinated note to which regulation 974-135E applies.

Subregulation 974-135E(4) sets out what profitability, insolvency or negative earnings conditions mean for the purpose of regulation 974-135E.

Subregulation 974-135E(5) puts beyond doubt that regulation 974-135E does not apply to the extent that there is negative retrospective impact on affected taxpayers.

Conditions on the obligation to which the regulation applies

Subregulation 974-135E(1) provides that regulation 974-135E applies to an obligation to pay interest on a relevant perpetual subordinated note on or after 1 July 2001.

Subregulation 974-135E(4) sets out the conditions which oblige or allow the payment of interest to be deferred (with or without compounding).

The conditions are that the issuer of the note is able or obliged to defer the payment of the interest (with or without compounding) beyond the date on which it would otherwise be payable if, on that date:

•                 profitability does not justify payment;

•                 the issuer is insolvent, or would become insolvent if the payment were made;

•                 a dividend has not been declared or paid on a class or classes of share capital of the issuer during a specified period that immediately precedes that date and is no more than 24 months; or

•                 the issuer's retained earnings are negative, or would be negative if the payment were made.

These profitability, insolvency, or negative earnings 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 interest cannot be deferred.  That is, there would be an obligation to make payment on the payable date if on that date none of the profitability, insolvency or negative earnings conditions apply.

Features of a relevant perpetual subordinated note to which the regulation applies

A perpetual subordinated note is a financial instrument generally used by ADIs to obtain finance.  It has the following features:

•                 no fixed term by the end of which the note must be repaid; and

•                 payment is subordinated to the interests of more senior creditors.

Perpetual subordinated notes that are subject to regulation 974-135E must have the following features:

Subregulation 974-135E(3)(a) - Upper Tier 2 instrument

Perpetual subordinated notes would ordinarily qualify as Upper Tier 2 capital for prudential purposes.

At the time of issuance, the note must not constitute, or meet the requirements of, a Tier 1 capital instrument.  Tier 1 capital is a type of capital classified by APRA for the purposes of prudential regulation.

A perpetual 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 is not within the terms of the regulation.

Subregulation 974-135E(3)(b) - debt interest

Regulation 974-135E only applies to perpetual subordinated notes which would be debt interests under section 974-20 of the Act but for one or more of the profitability, insolvency or negative earnings conditions.

Paragraph 974-135E(3)(c) and (e) - cumulative

The note must contain a condition that any deferred interest 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.

Paragraph 974-135E(3)(d) - issuer

The note must be issued by one of the following entities:

•                 an ADI that is a bank and is regulated for prudential purposes by APRA, or any of its subsidiaries that is regulated with the ADI for prudential purposes by APRA;

•                 an ADI that is a non-mutual building society and is regulated for prudential purposes by APRA, or any of its subsidiaries that is regulated with the ADI for prudential purposes by APRA;

•                 an entity that has undertaken to comply with prudential standards issued by APRA that deal with capital adequacy and is regulated for prudential purposes by APRA, or any of its subsidiaries covered by the undertaking; or

•                 an entity that is regulated for prudential purposes by a foreign prudential regulator that has a regulatory role comparable to that of APRA, and is subject to capital adequacy requirements comparable to those of APRA.

For the purposes of regulation 974-135E a foreign regulator is not 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. 

            Example 1

An entity is an authorised non-operating holding company with a wholly-owned ADI subsidiary.

If the entity has undertaken to comply with APRA's prudential standards dealing with capital adequacy and is regulated for prudential purposes by APRA, this regulation applies to relevant perpetual subordinated notes issued by the entity.  This regulation also applies to relevant perpetual subordinated notes issued by the entity's ADI subsidiary if it is covered by the entity's undertaking.

No negative retrospective application

As discussed above, regulation 974-135E applies to obligations to make payments of interest on a relevant perpetual subordinated note on or after 1 July 2001. 

As this application date precedes the date of registration of regulation 974-135E, 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 974-135E(5) provides that regulation 974-135E applies only to the extent that there is no negative retrospective application from the commencement of the regulation.  This is to make clear that regulation 974-135E will remain valid except for any negative retrospective application.

The following conditions are set out in subregulation 974-135E(5) in order for subregulation 974-135E(2), the main operative subregulation, to apply in relation to obligations to make payments of interest on or before the commencement of regulation 974-135E:

•                 the rights of a person, other than the Commonwealth or an authority of the Commonwealth, immediately before the commencement of the regulation, 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 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 the commencement of the regulation as a result of the application of the regulation to the obligation to pay the interest.

If the conditions outlined above are not met, regulation 974-135E 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.

Interaction between this regulation and the rest of the income tax law

Regulation 974-135E 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 profitability, insolvency or negative earnings conditions in a note that allows or obliges 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, regulation 974-135E 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 purpose of determining whether the note and a related scheme taken together satisfy the debt test or the equity test.

Example 2

An entity has an obligation to pay interest on a note to which regulation 974-135E applies.

The effect of regulation 974-135E 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 regulation 974-135E 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. Regulation 974-135E does not prevent the two schemes, constituted by the note and its related scheme, from being an equity interest as a result, for example, of subsection 974-70(2) of the Act.

[Item 5] - Regulation 995-1.01

Item 5 inserts a definition of 'insolvent' in Division 995 (Definitions) of the Principal Regulations.

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