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Allens Arthur Robinson

Focus: Capital Markets – July 2004

Debt capital markets: interest withholding tax developments

In brief: Partner David Clifford (view CV) and Senior Associate Thomas McAuliffe report on recent and proposed amendments to the Tax Act with implications for Australian interest withholding tax exemptions.

Range of instruments eligible for IWHT exemption broadened

As is well known, an exemption from Australian interest withholding tax (IWHT) is available for interest paid by a company in respect of a 'debenture', subject to the satisfaction of a public offer test and compliance with the other requirements of section 128F of the Income Tax Assessment Act 1936 (Cth) (the Tax Act). Over the past several years, various amendments to s128F have been enacted with a view to improving Australia's capital markets by removing impediments to Australian issuers of debt instruments and by reducing associated compliance costs. The latest amendments to s128F continue that process. The commencement date of these changes to the law is dependent on when the New International Tax Arrangements (Managed Funds and Other Measures) Bill 2004 receives Royal Assent; at this stage the Bill has only been introduced into the House of Representatives (on 24 June 2004).

Electronic debt interests: debentures or not?

Some instruments issued in the modern financial markets exist solely by virtue of electronic recording and are not evidenced by a document in hard or written form. Electronic promissory notes (EPNs) that exist within the Austraclear System are the most common local example of such instruments.

Sometimes offshore investors may be offered, or seek investments in, such instruments. Some debate has arisen in relation to whether EPNs can ever qualify for the s128F exemption from IWHT if they do not fall within the common law definition of 'debenture'. This is to be compared with the Corporations Act 2001 (Cth) definition of 'debenture', which does not require any document, with its reference merely to a 'chose in action'. However, strictly speaking, that definition is not relevant to the interpretation of s128F. The alternative view is that the s6(1) definition is broad enough to include EPNs and that such an interpretation does not give rise to any mischief. It is consistent with modern, sensible notions of what a document can be. Various Acts regarding statutory interpretation now extend the concept of a 'document' to include electronically recorded text. However, uncertainty in these matters is unacceptable to financial markets and this has led to offshore investors largely ignoring EPNs as a class of Australian investments.

The eligibility of EPNs, or other purely electronic debt rights, for the s128F exemption from IWHT will be resolved by proposed amendments to s128F which, when enacted, will amend s128F so that it also refers to 'debt interests', in addition to debentures, issued by a company.

Since 1 July 2001, the tax legislation has contained rules that govern the classification of financing arrangements as either a 'debt interest' or an 'equity interest' for Australian tax purposes, with that classification being based on the substance of those arrangements rather than their legal form. Where a financial instrument constitutes a 'debt interest' under those rules, it is intended that the legal form of that instrument should not affect the application of s128F to distributions payable on that instrument.

The proposed amendments will eliminate any uncertainty surrounding the application of s128F to EPNs and other instruments evidenced solely by electronic recording that satisfy the definition of a 'debt interest', regardless of their form.

To date, EPNs have not been actively issued to, or purchased by, non-residents, being intended as domestic Australian instruments and having none of the terms, such as tax gross-up provisions, of international debt market instruments. However, it remains the fact that such instruments may sometimes appear on non-residents' lists of investments and clarification of the position with regard to eligibility for the s128F exemption from IWHT will be timely and useful.

Other instruments that are debt interests

There are other instruments that are clearly not debentures, but which qualify as 'debt interests' for Australian tax purposes (for example, certain redeemable preference shares). Dividends payable on such 'non-equity shares' are included in the definition of 'interest' for withholding tax purposes and, therefore, may be subject to IWHT if paid to a non-resident investor. However, those dividends have not qualified for s128F exemption. Once the proposed amendments are enacted, IWHT will not be payable on the 'interest' payable on such instruments, provided they are issued in accordance with the requirements of s128F.

Offshore borrowings

Section 128GB provides an exemption from IWHT on interest paid by offshore banking units on 'offshore borrowings'. As some debt interests issued by offshore banking units would not be borrowings in a strict sense, the concept of 'borrow' will be updated so that it includes the raising of finance by the issue of a debt interest.

Transfer of IWHT exempt debentures to Australian branches of foreign banks

In 2001, s128F was amended to allow Australian branches of foreign banks to issue IWHT exempt debentures. Before that time, it was necessary for foreign banks to establish Australian subsidiaries in order to access the IWHT exemption. The Financial Corporations (Transfer of Assets and Liabilities) Act 1993 (Cth) is being amended to allow an Australian branch of a foreign bank to assume the obligations of its Australian subsidiary for IWHT exempt debentures previously issued by the subsidiary. It is intended that this will relieve foreign banks operating in Australia of the cost of maintaining Australian subsidiary entities for the sole purpose of preserving their entitlement to the IWHT exemption.

When will the changes apply?

All of the above measures will generally apply from the day on which the New International Tax Arrangements (Managed Funds and Other Measures) Bill 2004 is enacted.

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New s128FA: withholding tax exemption for certain unit trusts

From 23 June 2004 (the date on which the New International Tax Arrangements Act 2004 (Cth) received Royal Assent), it is possible for certain unit trusts to issue debentures in a way that will exempt interest paid on them from IWHT. In the past, unit trusts have only been able to access the IWHT exemption by having an interposed company undertake the borrowing and pay the interest.

The new s128FA exempts from IWHT interest paid by the trustee of an 'eligible unit trust' in respect of a debenture that was issued according to the requirements of s128FA (which, in the main, mirror those imposed by s128F). The intention behind s128FA is to put eligible unit trusts that are carrying on business in Australia on an equal footing with companies in relation to the taxation of their interest payments.

Eligible unit trusts are unit trusts that, at any time during a year of income, are:

  • unit trusts whose units are listed for quotation in the official list of a stock exchange, offered to the public, or held by 50 or more persons (with no group of fewer than 20 persons holding more than 75 per cent of them); or
  • unit trusts that are wholly owned by some combination of eligible unit trusts, complying superannuation funds with 50 or more members, pooled superannuation trusts, complying approved deposit funds, life insurance companies or public companies.

When enacted, the amendments relating to the extension of the IWHT exemption to non-debenture 'debt interests' will also apply to the issue of debt interests by eligible unit trusts.

Finally, for the purposes of the associates restrictions in s128FA, the trustee of an eligible unit trust is to be treated as if it were a company for the purposes of the definition of 'associate' in s318 of the Tax Act. In determining whether the trustee of an eligible unit trust is sufficiently influenced by another entity, regard should only be had to the influence on the trustee acting in that capacity, and not in any other capacity.

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