Commonwealth Numbered Regulations - Explanatory Statements

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INCOME TAX ASSESSMENT AMENDMENT REGULATION 2012 (NO. 2) (SLI NO 310 OF 2012)

EXPLANATORY STATEMENT

Select Legislative Instrument 2012 No. 310

[Issued by authority of the Assistant Treasurer]

Income Tax Assessment Act 1997

Income Tax Assessment Amendment Regulation 2012 (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 Regulation amends the Income Tax Assessment Regulations 1997 (ITAR 1997) to remove uncertainty concerning the tax treatment of certain hybrid capital instruments (that is, capital instruments that have both debt and equity characteristics) as a result of Australia's implementation of the Basel III capital reforms and insurance capital reforms.

The prudential capital adequacy requirements

The Basel III capital reforms and insurance capital reforms apply to entities regulated by the Australian Prudential Regulation Authority (APRA) and certain other entities from 1 January 2013.  The Basel III capital reforms are the package of reforms released by the Basel Committee on Banking Supervision to raise the level and quality of regulatory capital in the global banking system.  These reforms strengthen the capital framework for authorised deposit-taking institutions with the objective of promoting a more resilient global banking system.  The insurance capital reforms are the package of reforms made to the capital adequacy requirements for general insurers and life insurers.  These reforms strengthen the capital framework for general insurers and life insurers and ensure greater alignment of the capital standards across industries.

For the purposes of this explanatory statement, the Basel III capital reforms and the insurance capital reforms are collectively referred to as the capital adequacy reforms.

To implement these reforms, APRA's capital adequacy prudential standards have been amended.  Among other things, the capital adequacy reforms require all regulatory capital to be capable of absorbing losses of the entity, or regulated group, if required to do so (the non-viability condition).  Broadly, the non-viability condition requires that a regulatory capital instrument issued by an APRA regulated entity, or its subsidiary, be written off or converted to common equity if APRA or a comparable foreign regulator considers that the issuer, or its parent, would be non-viable or require an injection of public sector funding without such a write off or conversion.

The debt-equity tax rules

Division 974 of the Act provides rules to distinguish between debt and equity for various income tax purposes.  One important implication of the debt-equity distinction is that returns on debt interests may be tax deductible but are not frankable.  Returns on equity interests may be frankable but are not deductible.  That is, returns paid on debt interests that are tax deductible reduce the payer's taxable income.  In contrast, returns paid on equity interests that are frankable allow the recipient to obtain a tax offset to reflect company tax paid by the payer.

Broadly, the debt-equity distinction focuses on a single organising principle:  whether an issuer has, in substance or effect, 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 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.

Overview of the Regulation

The purpose of the Regulation is to facilitate debt tax treatment of certain capital instruments issued by entities that are regulated, either directly or as part of a group, for prudential purposes by APRA and comply with the new Tier 2 capital requirements, including the non-viability condition.

It does so by overlooking the contingency that the non-viability condition imposes on the obligation to pay the principal or interest on the capital instrument for the purpose of determining whether the obligation is a non-contingent obligation.

The Regulation provides that an obligation to pay the principal or interest on a relevant capital instrument that contains the non-viability condition is not precluded from being a non-contingent obligation and therefore the capital instrument is not precluded from being a debt interest.

While facilitating the debt treatment of these capital instruments, the Regulation does not of itself deem such capital instruments to be debt interests or make returns on the capital instruments tax deductible.

Consultation on the implementation of the amendments was conducted publicly via the Treasury website from 13 July 2012 to 10 August 2012.

Consultation on exposure draft regulations was conducted publicly via the Treasury website from 31 October 2012 to 14 November 2012. 

The Regulation takes into account the submissions and issues raised during the consultations.

Details of the Regulation are set out in the Attachment.

The Regulation commences the day after it is registered.

The Regulation is 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 Regulation may be exercised.

                                                                 

                                                                  Authority:  Section 909-1 of the

                                                                                     Income Tax Assessment Act 1997


 

Attachment

Details of Income Tax Assessment Amendment Regulation 2012 (No. 2)

Section 1 -- Name of Regulation

This section provides that the title of the Regulation is the Income Tax Assessment Amendment Regulation 2012 (No. 2).

Section 2 -- Commencement

This section provides that the Regulation commences on the day after it is registered.

Section 3 -- Amendment of Income Tax Assessment Regulations 1997

This section provides that the Income Tax Assessment Regulations 1997 (the Principal Regulations) are amended as set out in Schedule 1.

Schedule 1 -- Amendments

[Items 1 and 2]

Items 1 and 2 update the title of regulations 974-135D and 974-135E to clearly distinguish between the regulations that apply to the different capital instruments.

[Item 3] -- regulation 974-135F

Item 3 inserts a new regulation 974-135F (the regulation) into Subdivision 974-F of the Principal Regulations.

The regulation provides that, for certain capital instruments, the obligation to pay the principal or interest is not precluded from being a non-contingent obligation for the purpose of working out whether the interest is a debt interest where the obligation is subject to the non-viability condition.

Structure of the regulation

Subregulation 974-135F(1) sets out that the regulation applies to obligations to pay the principal or interest on a relevant term cumulative subordinated note from the commencement of the Regulation.

Subregulation 974-135F(2) is the primary operative provision.  It provides that an obligation to pay the principal or interest on a relevant term cumulative subordinated note is not precluded from being a non-contingent obligation solely because of the non-viability condition in the note.  The non-viability condition, upon being triggered, requires the note to be written off or converted into ordinary shares of the issuer or a parent of the issuer.  Without the regulation, the condition may cause the obligation to be considered to be contingent and so preclude the note from being a debt interest.

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

Subregulation 974-135F(4) sets out what a non-viability condition means for the purpose of the regulation.

Subregulation 974-135F(5) sets out what a non-viability trigger event means for the purpose of the regulation.

Conditions on the obligations to which the regulation applies

Subregulation 974-135F(1) provides that the regulation applies to an obligation to pay the principal or interest on a relevant term cumulative subordinated note issued on or after the commencement of the regulation.  The application date allows affected entities to prepare for the commencement of the capital adequacy reforms.

Subregulation 974-135F(4) sets out the non-viability condition.  The condition is that the note is obliged to be written off or converted into ordinary shares of the issuer or a parent of the issuer upon the occurrence of a non-viability trigger event.

The non-viability trigger event is described in subregulation 974-135F(5) and constitutes either:

                the issuance of a written notice from APRA or a comparable foreign regulator to the issuer of the note, or a parent entity of the issuer, stating that conversion or write off of capital instruments is necessary because without it APRA or the foreign regulator considers that the issuer, or the parent entity, will become non-viable; or

                the written determination from APRA or a comparable foreign regulator to the issuer, or a parent entity of the issuer, that without an injection of capital or equivalent support from the public sector the issuer, or the parent entity, will become non-viable.

For the purpose of this regulation, a foreign regulator is not a comparable foreign regulator unless it issues capital adequacy requirements and administers those requirements that, in material respects, are substantially similar to those made and administered by APRA.

The non-viability condition defined in subregulation 974-135F(5) is consistent with prudential standards made by APRA under:

               section 11AF of the Banking Act 1959;

               section 32 of the Insurance Act 1973; and

               paragraph 230A(1)(a) of the Life Insurance Act 1995.

But for the non-viability condition, the terms of the note would ordinarily mean that payments of principal and interest are non-contingent obligations.

Features of the term cumulative subordinated note to which the regulation applies

A term cumulative 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 cumulative subordinated notes that are subject to the regulation must have the following features:

Paragraph 974-135F(3)(a) -- issuer

The note must be issued by an entity that is regulated by APRA for prudential purposes or is part of a group that must comply with APRA's capital adequacy requirements.

Paragraph 974-135F(3)(b) -- Tier 2 instrument

The relevant notes ordinarily qualify as Tier 2 capital for prudential purposes under the capital adequacy prudential standards.

At the time of issuance, the note must not constitute, or meet the requirements of, a Tier 1 capital instrument for prudential purposes under the capital adequacy prudential standards. 

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 issuer, a connected entity, or a group of connected entities that are regulated as a group, has an excess of Tier 1 capital.  The regulation does not apply to 'excess Tier 1 capital instruments'.

Paragraph 974-135F(3)(c) -- term

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.  A term longer than this more closely resembles permanent capital of the issuer, a feature more commonly associated with equity than with debt.

Paragraph 974-135F(3)(d) -- cumulative

The note must contain a condition that any deferred interest must accumulate until such time as the payment is made or the non-viability trigger event occurs.  The deferred payments do not have to compound; that is, interest does not have to be paid on any deferred payment.

Paragraph 974-135F(3)(e) -- accounting liability

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.

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

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 Income Tax Assessment Act 1997 (the Act), that certain obligations are not prevented from being non-contingent obligations as a result of the non-viability condition contained in the note.  In order for a note to be classified as a debt interest it still needs to satisfy the debt test in subsection 974-20(1) of the Act.  Furthermore, the regulation does do not of itself provide that returns on eligible notes are tax deductible.

The regulation also does not override the 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 1

Lyra Co has an obligation to make principal and interest payments on a note to which this regulation applies.

The effect of the regulation applying is that a particular contingency in relation to these obligations are disregarded for the purpose of determining whether Lyra Co has an effectively non-contingent obligation to make those payments.

As a result of the regulation applying, the scheme (that is, the note), when 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 entered into with Bon Bon Co, a connected entity.  There is nothing in this regulation that prevents the two schemes, constituted by the note and its related scheme from being an equity interest as a result; for example, because of subsection 974-70(2) of the Act applying.


Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Income Tax Assessment Amendment Regulation 2012 (No. 2)

This Legislative Instrument is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview of the Legislative Instrument

The purpose of this Legislative Instrument is to facilitate debt tax treatment of certain term cumulative subordinated notes issued by an entity that is regulated by APRA for prudential purposes or is part of a group and comply with the Tier 2 capital requirements set out as a result of Australia's implementation of the Basel III capital reforms and insurance capital reforms.

The Legislative Instrument provides that an obligation to pay the principal or interest on a relevant capital instrument is not precluded from being a non-contingent obligation (and therefore the note is not precluded from being a debt interest) by the loss absorption clause (non-viability condition) contained in the capital instrument.  The existence of such a condition is necessary for the note to be recognised in the issuer's regulatory capital for prudential purposes.  Without the Legislative Instrument, this condition may make the obligation a contingent obligation, as the obligation would be contingent on the non-viability condition not being triggered.

While facilitating the debt treatment of these capital instruments, the Legislative Instrument does not of itself deem such capital instruments to be debt interests or make returns on the notes tax deductible.

Human rights implications

This Legislative Instrument does not engage any of the applicable rights or freedoms.

Conclusion

This Legislative Instrument is compatible with human rights as it does not raise any human rights issues.

 


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