ATO ID 2009/154: Interest withholding tax - in substitution for interest
Date of decision: 3 December 2009
Year of income: Year ended 30 June 2009
Business line: Public Groups and International

Issue
Is a payment on a convertible security 'interest' within the extended definition in paragraph 128A(1AB)(b) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Decision
No. A payment on a convertible security is not 'interest' within the extended definition in paragraph 128A(1AB)(b) of the ITAA 1936 because the convertible security is not a loan and therefore the payment cannot be 'in substitution' for interest.

Facts
An Australian entity issues convertible securities (securities). Each security carries an entitlement to payment of 10% per annum on the face value of the security. A security holder has the right to exchange the securities for interests in the entity, but has only a contingent right to redeem the face value of securities. The securities rank below all debts of the Australian entity. The securities are redeemable at the option of the Australian entity.

Reasons for decision
Summary: For the purposes of Division 11A of the ITAA 1936, 'interest' includes an amount 'to the extent that it could reasonably be regarded as having been converted into a form that is in substitution for interest' (paragraph 128A(1AB)(b) of the ITAA 1936). 'Converted into a form that is in substitution for interest' entails postulating on reasonable grounds that the amount was 'instead of' interest. This requires that the amount is in substance and effect the same as the interest for which it was substituted. In order for a payment to be in substitution for interest, it must have been possible for 'interest', in the ordinary sense of the word, to have been paid. Interest is, in essence, compensation to a lender for being kept out of the use and enjoyment of a principal sum ( Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693). In order for a payment to be interest, it must be paid in respect of keeping a person out of the use and enjoyment of a principle sum. It must be paid in respect of an amount of money which the person can require to be repaid either upon demand or at a fixed date; that is, a debt. The ATO view on the nature of a loan is contained in Taxation Ruling TR 2002/15. The following excerpts of that ruling explain the consequences of contingency on and subordination of the obligation to repay an amount. 65. The critical question then is whether there is a debt in existence prior to the happening of the contingencies and subject to the terms and conditions of the notes, or whether the obligation to repay Moneys Owing is merely contingent. 66. An analogous situation arises with a guarantor's right of indemnity. Before payment by the guarantor, the right is subject to contingencies, namely the default by the debtor then a request for payment by the creditor. 67. The Court of Appeal in Re A Debtor [1937] 1 All ER 1 confirmed a long line of authority supporting the proposition that the debt due to the guarantor by the debtor under the implied contract does not arise until the guarantor has been called on to pay, and does pay, the creditor under the guarantee. Greene LJ commented at 8: 'The implied undertaking to indemnify is an undertaking to reimburse the guarantor upon the happening of a contingency, viz., payment by the guarantor to the creditor, and until that contingency happens, there is no debt.' 68. In the case of a Note, on one view there is no debt until a contingency occurs, being an event of default (such as the insolvency of the Issuer), or a liquidation event. 69. Another view is that there is no debt at all. Upon winding-up, the Holders' rights are subordinated until all claims of senior creditors are paid in full. The Holders may never receive the full face value of the Notes. In fact, the Holders do not have a right to sue for the sum due as a debt but may merely have a contractual right to enforce their claims behind those of the senior creditors. The securities do not give the security holder a right to recover the face value of the securities from the Australian entity, other than in limited circumstances. Further, the right to recover the face value of the security is subordinated to all debts of the Australian entity. As a result of the contingency and the subordination of the right to repayment, the securities do not give rise to a debt. As the securities do not give rise to a debt, it is not possible for interest to have been paid on the securities. Therefore, the payments that are made on the securities cannot have been made in substitution for interest.

Legislative references: Income Tax Assessment Act 1936 paragraph 128A(1AB)(b) Division 11A
Case references: Federal Commissioner of Taxation v The Myer Emporium Ltd (1987) 163 CLR 199 87 ATC 4363 (1987) 18 ATR 693
Related public rulings and determinations: Taxation Ruling TR 2002/15
Subject references: Deemed interest Interest income Non resident interest withholding tax Withholding taxes