5 May 2004 NV:SG N. Velardi (03) 9607 9382 E-mail: nvelardi@liv.asn.au The Manager Taxation of Financial Arrangements Unit Business Income Division Revenue Group The Treasury Langdon Crescent Canberra ACT 2600 Dear Sirs, RE: REVIEW OF THE DEBT/EQUITY PROVISIONS OF THE INCOME TAX LAW REGARDING CERTAIN AT CALL LOANS We refer to the Discussion Paper released by the Minister for Revenue on 6 April 2004. The Law Institute (LIV) welcomes the opportunity to comment on the paper. Attached is the LIV s submission. If you would like to discuss any of the matters raised please do not hesitate to contact me or Natalina Velardi on 9607 9382. Yours sincerely, Christopher Dale President Law Institute of Victoria
Law Institute of Victoria ( LIV ) Submission to the Taxation of Financial Arrangements Unit, Business Income Division, Revenue Group on Debt/Equity Regime Division 974 and at call loans 1. Preliminary We refer to the Discussion Paper released by the Minister for Revenue on 6 April 2004 entitled Review of the debt/equity provisions of the income tax law regarding certain at call loans ( the Paper ) and set out below our comments. We note at the outset that the Paper defines an at call loan to be a loan repayable on demand by the lender. We further note that the Paper appears to contemplate the fact that such loans may also require the payment of interest on the principal. For the purposes of certainty in this submission, it is assumed that the existence or absence of an obligation to pay interest will not affect the characterisation of a loan as being at call. The relatively short response time for comment on the Paper has resulted in this submission being relatively brief in its setting out of background facts and limited in the degree of analysis undertaken. The Law Institute will be happy to make further submissions if necessary. 2. Essential Issue The essential issue for at call loans is that moneys loaned by shareholders to their company and presently treated as a debt will be treated as equity for tax purposes after 1 July 2004 unless the terms of the loan are so drafted as to bring it within the definition of a debt interest in accordance with tests set out in section 974-20. The consequence of not being so characterised is that the loans will be treated as an equity interest. As a result, amongst other things, interest payable on the loan principal will not be deductible to the company and will be treated as a dividend in the hands of the shareholders. Perhaps more importantly, repayment of the principal will be treated in a similar fashion to a return of capital on shares and will therefore be subject to the restraints imposed by the Income Tax Assessment Acts on returns of capital to shareholders. In particular, the provisions of section 45B will potentially apply to impose tax on the repayment if it is paid in circumstances where a dividend could have been paid instead. 3. Background It is understood that representations to Government were made concerning at call loans during the course of passage of the 2001 Bill. It would appear to have been accepted that there was a genuine case for exempting such loans from the broad sweep of the Division
974 treatment of equity interests. In particular, it would appear that as a consequence of those representations: the non-arms length provisions of the debt test in section 974-75(1) were amended; the transitional relief provisions of section 974-75(4) were inserted; and the comments in the Supplementary Explanatory Memorandum referred to on page 2 of the Paper concerning allowing taxpayers sufficient opportunity to review and organise such arrangements [i.e. at call loans] so that they fall on the particular entity s preferred side of the debt/equity border were made. The assumption appears to have been that parties could use the provisions of the Division to draft their loan agreements to fall within the definition of debt interest with relative ease. In particular it appears to have been assumed that by drafting loans to require a maximum repayment period of 10 years for principal, a loan which was otherwise at call within that period would satisfy the requirements of the debt test. This view appears also to be accepted by the Paper (see page 4). Whilst it would appear that the 10 year requirement for satisfying the debt test discussed to date would have general application, unless otherwise indicated our comments below are directed to small to medium enterprise ( SME ) companies. 4. Discussion Issues of Concern 4.1 Our threshold concern is that the Government is seeking to impose upon the owners of SME companies the obligation to bring into existence a document which requires interpretation of the relevant legislation. In this regard, the position under Division 974 can be distinguished from, for example, the loan agreement requirements of Division 7A. In the latter case, the essential requirements of the loan are set out in the legislation. In the case of the regime requirements, taxpayers are required to interpret the legislation and ensure that their loan agreement satisfies tests which require analysis and interpretation. The assumption that imposing a 10 year maximum term will satisfy the debt test may or may not be correct for the reasons outlined below. As a general principle, however, making assumptions about the operation and interpretation of legislation where the consequences of those assumptions being incorrect will fall to the taxpayer represents bad legislative practice. In the present case, it casts upon taxpayers the obligation and cost of resolving inadequacies and uncertainties contained within the legislation itself. 4.2 As matters presently stand therefore, taxpayers are required to draft documents to ensure that at call loans fall within the debt test of section 974-20 and otherwise satisfy the requirements of Division 974. The drafting of the provisions generally, and the definitions adopted in particular, pose significant problems for a taxpayer faced with this task. For example, to come within the debt test a loan agreement must satisfy the following definitional requirements: (a) it must provide for an effectively non-contingent obligation to provide a financial benefit (section 974-20(1)(c)). The former term is undefined in the legislation. Further it is required by the legislation to be interpreted in accordance with economic substance rather than legal form (section 974-10(2)); and (b) the loan established under its terms must end no later than 10 years from the time when the shareholders or their associates first provided a financial benefit to the company (sections 974-20(1)(d) read in conjunction with sections 974-35(1)(a)(i), 974-35(2) (4)). Financial benefit is defined but is not necessarily limited to the shareholder s advance of the relevant loan funds to the company in question (section 974-160(1)).
Paragraphs (c) and (d) of the debt test requirements of section 974-20(1) are of particular relevance to this analysis and are addressed in greater detail below. 4.3 To compound the uncertainties for the taxpayer, the above definitions and the drafting of Division 974 generally are more consistent with the drafting of antiavoidance legislation than normal parliamentary drafting. Such drafting places an unacceptable level of risk and uncertainty on those with the obligation to comply with them. 4.4 In addition to the problems of definition referred to, taxpayers are faced with conceptual difficulties implicit within the debt test which neither the Paper nor (as far as we are aware) the Commissioner of Taxation s releases to date have addressed. (a) While it appears tolerably clear that the requirements of paragraph (d) of the test section can be satisfied if one can successfully establish that the loan principal must be repaid within 10 years, it is by no means clear what must be done to satisfy the requirements of paragraph (c). As indicated above, the latter paragraph requires that under the loan terms the company has an effectively non-contingent obligation..to provide a financial benefit at the time when the advance is made by the shareholder to the company. In particular it is nowhere clearly stated that, for example, the Commissioner will not seek to take the view at a later time that an interest free loan between non-arms length parties for a period of up to 10 years after the time of advance and repayable on demand at any time within that period does not fit the description of an effectively non-contingent obligation and therefore will not satisfy the debt test. In this regard one is left to ponder the coincidence that a 10 year repayment obligation successfully satisfies both tests and to inquire: (i) (Leaving aside for a moment the requirements of the separate test of paragraph (d)) if, for example, the parties set a 50 year or 90 year time period for repayment would that still amount to an effectively noncontingent obligation? The implication from a reading of the Explanatory Memorandum is that it may not. (ii) If the answer is that such a protracted period for repayment would not satisfy the description of an effectively non-contingent obligation for the purposes of the Act, what period would satisfy it? In particular, on what grounds can it be safely assumed that a 10 year term is a sufficiently short period to ensure that that the obligation to repay can properly be described as an effectively non-contingent obligation? Can a taxpayer, for example, legitimately proceed from the comments made in the Paper regarding the acceptability of a 10 year period for the purposes of the test in paragraph (d), to assume without further assurance that a 10 year loan will also satisfy the effectively noncontingent obligation test of paragraph (c)? It is submitted that no such assumption can properly be made on the basis of the present drafting of the legislation. Accordingly,if taxpayers are to be compelled to bring a document into existence, it is further submitted that there must be a clear legislative statement on which taxpayers can safely prepare that document. 4.5 It is not clear what role the payment of interest on at call loans plays. In most cases, the payment of interest on such loans is unlikely tot be a matter of concern to the parties, but it may be in some circumstances. There appears to be an assumption in the Paper that such loans somehow provide to the parties a basis on which to regulate their tax affairs to the detriment of the revenue by charging differential rates of interest as and when they choose. This is incorrect and is not a proper basis upon
which to suggest that at call loans provide a mechanism for frustrating the collection of revenue, as appears to be implied in the comments regarding flexible management of deductions on page 9. Ure v F.C. of T 81 ATC 4100 makes it clear that in non-arms length circumstances the deductibility of the interest rate applied will be subject to consideration of the arms length alternatives. In the case of loan principal that can be called up at any time, the lender s ability to make that call not only affects the present value of the loan debt (as acknowledged in section 974-35) but will also affect the rate of interest that can commercially be demanded by the lender on the principal advanced. It is that rate which will determine the deductibility of the loan and not the decisions of the non-arms length parties. In this regard, the Paper appears to proceed from an incorrect premise. 4.6 It is noted that the paper contemplates that at call loans which do not satisfy the debt test after 1 July 2004 may attract the operation of section 45B and that this reflects the in substance approach to distinguishing debt and equity. In the majority of circumstances concerning at call loans, section 45B will effectively have a profits first effect an effect which the Commissioner expressly advised would not apply to at call loans in the Q & A information placed on the ATO website in the early stages of the debt/equity regime (see At call loans questions and answers at page 4). The following example (which is not drawn from ATO materials) illustrates the potential problems from a practical perspective: Example: Mr and Mrs A are the sole shareholders in A Pty Ltd. On 30 May 2001 they advanced $150,000 (being the proceeds on sale of their holiday house) to A Pty Ltd. when the company s overdraft facility was withdrawn by its bank. The company trades profitably for the succeeding years and by August 2004 has $350,000 in credit in the bank, representing the after-tax profits of the company at that time. They determine that it is time for their $150,000 to come out. Their accountant advises them that they can either declare a franked dividend or cause A Pty Ltd to repay its debt. Their marginal tax rates are both at 48.5%. Franked dividends totaling $150,000 would therefore result in Mr and Mrs A paying tax of $27,750 (i.e (48.5 30 = 18.5% x $150,000) if they elect to get their advance back via dividend payments. They elect instead to have the debt repaid in August 2004. At the time of repayment there is no formal loan agreement in place and no limitation has been imposed by the parties as to the period of the loan. After 1 July 2004 the undocumented loan will be an equity interest and the loan payment will be deemed to be a non-share capital return. Section 45B(7) will deem the loan repayment to be a distribution of share capital for the purposes of section 45B. Section 45B directly targets the substitution of a capital payment for a dividend where there is a purpose (not a sole or dominant purpose) of obtaining a tax benefit. If the Commissioner chose to exercise his powers under the section (and it is difficult to see why he would not) the consequence is that the $150,000 would be received by Mr and Mrs A as an unfranked dividend. (i.e. $150,000 x 48.5% = $72,750). If the payment became apparent in an audit two years later Mr and Mrs A would also be liable to pay penalties of 25% on the unpaid tax plus a further 25% in GIC ( 2 years at 12.5% p.a.) In light of our comments above concerning uncertainty and complexity, it is perhaps appropriate to note at this point that the same result would arise if Mr and Mrs A and their company had documented the loan before 1 July 2004, but the drafting was
deficient e.g. if the loan agreement had a repayment date of 10 years commencing from the date the agreement was signed, instead of commencing on the date of the advance to the company (30 May 2001). (See our comments in para 2.2 and more particularly sections 974-35(1)(a)(i) and 974-55(1)(d) which require that the 10 year performance period must commence on the date on which Mr and Mrs A first provided a financial benefit to A Pty Ltd by advancing the $150,000.). 4.7 In one sense, the comments in the Paper concerning section 45B go to the heart of what is submitted to be a conceptual flaw in the debt/equity regime as presently drafted. The difficulty with an at call loan as far as the Paper is concerned is that it falls prima facie within the concept of equity adopted in the legislation and any exclusion will need to be justified. The difficulty with the concept of equity adopted in the legislation as far as SMEs are concerned is that while it may be appropriate for public companies and other forms of perpetual entity, it simply does not fit within the common paradigm of how SMEs actually operate. Most SMEs fit more readily within a concept of equity which involves a far greater degree of flexibility and interplay of capital flow between the owners and the entity. In this regard, the structure of a partnership is a more appropriate starting point for comparison. Indeed partnerships would be the preferred structure for many SMEs were it not for the perils of unlimited liability. As a consequence, the typical SME corporate structure comprises a relatively small issued capital, with the balance of proprietors funds being in the form of shareholders loans. Those loans are frequently at call and are undocumented or documented in the most simple terms. They are usually interest free to the extent that they are contributed in proportion to the equity of the respective shareholders. 4.8 It is apparent that to impose a legislative platform based on an entirely different concept of equity from the one which is presently applicable for SMEs is likely to lead to unexpected and potentially harsh consequences. In this regard it is noted that from a tax perspective, returns of equity tend to be tax free, while returns of dividends are likely to produce revenue for Government. Accordingly, from Treasury s viewpoint a tax system which adopts a rigid concept of equity based on a public company model is attractive because such structures can be compelled (using section 45B and similar provisions) to deliver a profits first return to shareholders which maximises the return to the Revenue. It is submitted however that taxation legislation which fails to properly take prevailing SME commercial structures into account or which seeks to change those structures to achieve a fiscal objective is misconceived. It is further submitted that the potential problems posed by the legislation for SME corporate structures in respect of at call loans significantly outweigh the administrative and anti-avoidance benefits afforded to the ATO and Treasury in their regulation of some of the tax practices of large corporates. The tax outcome of the fact situation in the above example will be construed (correctly, it is submitted) as a commercial nonsense by anyone involved in a SME company. It is submitted that it is not to the point to argue that the operators of SME companies do not understand the correct concepts of equity in corporations. The point which must properly be addressed is the extent to which market place reality should be varied to suit the objectives of revenue collection. 5. Submissions On the basis of the foregoing, it is submitted that in the absence of any reconsideration of the debt/equity regime and its effect on SMEs as a whole either: 1. the 10 year maximum loan term requirements hitherto anecdotally advanced as acceptable by the ATO and now confirmed in the Paper should be legislated in
clear and unequivocal terms. If loan agreements are to be required to be prepared, the legislation should clearly and unambiguosly state that a loan (whether with or without interest) the principal of which is repayable at any time at the option of either party but which must be repaid no later than 10 years from the advance date will satisfy the debt test; or 2. there be a legislated carve out for at call loans to SMEs. If that is to occur, the identification of which structures will fall within the category of SME is clearly critical. It is submitted that to adopt the Simplified Tax System criterion as representative of small to medium enterprises is totally unacceptable and disregards the fact that at call loans are equally relevant to medium sized businesses as to corner shop operations. Our understanding is that very few businesses currently avail themselves of the STS characterisation and for the Paper to suggest such a limited operation be given to the exclusion of at call loans at this late date is a matter of concern. The clear implication emerging from the amendments to the original Bill and the transitional provisions of section 974-75(4) was that the imposing of a 10 year fixed term would be sufficient to enable all entities with at call loans to satisfy the debt test. We are not aware of any suggestion in any of the information emanating from the ATO or Treasury that a limitation to a very small and unrepresentative category of SME corporate structures would be imposed.