Private ruling: On-market share buy-back - ToFA
Published: December 2014
Ruling period: Year ended 30 June 2015 to 30 June 2019.
Date scheme commenced: Year ended 30 June 2015.

Ruling: Q1: To the extent the proposed borrowings are used to replace shareholders' equity employed in the business activities of Company A (as the head company of the Company A Australian income tax consolidated group (Company A TCG)) to gain or produce assessable income, will Company A (as the head company of the Company A TCG) be entitled to claim a deduction under subsection 230-15(2) of the Income Tax Assessment Act 1997 (ITAA 1997) for any loss made from interest coupons paid on the proposed borrowings used in the business to gain or produce assessable income? | A1: Yes. | Q2: To the extent the proposed borrowings are used to replace shareholders' equity employed in the business activities of Company A (as the head company of the Company A TCG) to derive non-assessable non-exempt (NANE) income under former section 23AJ of t he Income Tax Assessment Act 1936 (ITAA 1936) or section 768-5 of the ITAA 1997, will Company A (as the head company of the Company A TCG) be entitled to claim a deduction under subsection 230-15(3) of the ITAA 1997 for any loss made from interest coupons paid on the proposed borrowings used in the business to derive NANE income under former section 23AJ or section 768-5? | A2: Yes.

Relevant facts and circumstances: 1. Company A is an Australian resident public company listed on the Australian Securities Exchange (ASX) and is the head company of an Australian income tax consolidated group (Company A TCG). The Company A Global Group consists of Company A and its Australian and foreign subsidiaries. 2. Company A is proposing to commence a new on-market share buy-back program to be undertaken in tranches over a period of no more than 12 months, by a share broker acting on behalf of Company A via the following steps: • The share broker will use Company A's funds to purchase shares in Company A on-market through the ASX; • The shares bought back will be cancelled pursuant to section 257H of the Corporations Act 2001 . 3. Company A's cash funding requirements include ongoing operational funding, payment of dividends, capital investments and business acquisitions, the buy-back of shares and other financing activities. The funds generally available to Company A include operational cash flows, external borrowings and dividends received from foreign subsidiaries. 4. Company A's existing cash reserves and existing Australian operational cash flows expected in the next 12 months are not anticipated to be sufficient to fully-fund the proposed on-market share buy-back and so Company A intends to finance the proposed on-market share buy-back through of the following: • Company A to take out external borrowings (to be used first); and • Utilising Company A's existing cash reserves sourced from dividends received from its foreign subsidiaries and cash arising from Company A's Australian business operations. 5. Under the proposed terms of the borrowings: • Company A will have the right to receive, in cash, the face value of the borrowings; • Company A will have an obligation to repay, in cash, the face value of the borrowings; and • Company A will have an obligation to pay, in cash, interest coupons annually. 6. The shareholders' equity of Company A (as the head company of the Company A TCG) consists of share capital and realised profit reserves. The amount of the shareholders' equity is higher than the amount of the proposed borrowings. 7. Based on historic income tax returns and forecasts, the income of Company A (as the head company of the Company A TCG) consists of: • assessable income; and • non-assessable non-exempt (NANE) income by reason of the application of former section 23AJ of the ITAA 1936 (section 23AJ dividend) or section 768-5 of the ITAA 1997 (section 768-5 dividend). Company A (as head company of the Company A TCG) has no any other types of NANE income, nor any exempt income or disregarded capital gains. 8. Company A has not made any TOFA tax-timing elections under Division 230 of the ITAA 1997. Assumption(s) 9. The proposed on-market share buy-back is an 'on-market purchase' for the purposes of Division 16K of Part III of the ITAA 1936. 10. The proposed borrowings are taken to be debt interests under Division 974. 11. Where a former section 23AJ dividend or (section 768 5 ) dividend has not actually been derived, there is a reasonable expectation, together with a more than theoretical potential, for such a dividend to be paid by each of the foreign subsidiaries of Company A (as head company of the Company A TCG).

Relevant legislative provisions: Income Tax Assessment Act 1936 former section 23AJ | Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 subsection 230-15(2) | Income Tax Assessment Act 1997 subsection 230-15(3) | Income Tax Assessment Act 1997 subsection 230-45(1) | Income Tax Assessment Act 1997 paragraph 230-45(2)(a) | Income Tax Assessment Act 1997 section 230-50 | Income Tax Assessment Act 1997 section 701-1 | Income Tax Assessment Act 1997 section 768-5 | Income Tax Assessment Act 1997 paragraph 820-40(1)(a) | Income Tax Assessment Act 1997 Division 974 | Income Tax Assessment Act 1997 Section 974-160

Reasons for decision: Summary: Subsection 230-15(2) Company A (as the head company of the Company A TCG) is entitled to a deduction under subsection 230-15(2) if the Company A TCG makes a loss from a financial arrangement, but only to the extent that: (a) the Company A TCG makes it in gaining or producing its assessable income; or (b) the Company A TCG necessarily makes it in carrying on a business for the purpose of gaining or producing its assessable income. Loss from a financial arrangement The Company A TCG has a 'financial arrangement' under subsection 230-45(1), if the Company A TCG has, under an arrangement: • a cash settlable legal or equitable right to receive a financial benefit; or • a cash settlable legal or equitable obligation to provide a financial benefit; or • a combination of one or more such rights and/or one or more such obligations. Subsection 230-45(1) may exclude arrangements under which you have a right to receive or an obligation to provide a thing that is not a financial benefit or is not cash settlable. Subsection 974-160(1) provides that a 'financial benefit' means anything of economic value. Paragraph 230-45(2)(a) provides that a right you have to receive, or an obligation you have to provide, a financial benefit is 'cash settlable' if the benefit is money or a money equivalent (as defined in subsection 995-1(1)). Under the proposed borrowings: • Company A will have the right to receive, in cash, the face value of the borrowings; • Company A will have an obligation to repay, in cash, the face value of the borrowings; and • Company A will have an obligation to pay, in cash, interest coupons annually. These rights and obligations are legal rights to receive and legal obigations to provide financial benefits because the borrowings and interest coupons are of economic value. These rights and obligations are 'cash settlable' because they are required to be settled in cash. Accordingly, as the borrowings will consist entirely of cash settlable legal rights to receive financial benefits and obligations to provide financial benefits, they will satisfy the definition of a 'financial arrangement' under subsection 230-45(1). For completeness, the borrowings will not be a 'financial arrangement' under section 230-50 as the borrowings are taken to be debt interests under Division 974. The accruals and realisation methods under Subdivision 230-B are the default tax-timing methods which apply to financial arrangements that are not subject to any of the elective tax-timing methods of Division 230. The Company A TCG has not made any such tax-timing elections. Accordingly, the tax-timing in respect of the borrowings is determined under Subdivision 230-B. On ceasing to have the borrowings a balancing adjustment must be made under Subdivision 230-G. Deduction for any loss made from interest coupons Under subsection 230-15(2), the Company A TCG is entitled to deduct any loss that is referable to the obligation to pay interest coupons on the borrowings to the extent the Company A TCG makes the loss in gaining or producing its assessable income; or necessarily makes the loss in carrying on a business for the purpose of gaining or producing its assessable income. The words 'in gaining or producing' adopted by subsection 230-15(2) reflect the same nexus enquiry as for the first positive limb of section 8-1. These words require an examination of whether or not there is a sufficient nexus or connection between the identified loss and an income producing activity. Whether a sufficient nexus exists will depend on the nature of the loss and the degree of its connection with the activities by which the taxpayer is gaining or producing the relevant income. Case law that has examined the meaning of 'in gaining or producing' in the context of a nexus requirement also provides guidance to the application of subsection 230-15(2). In relation to interest deductibility, Taxation Ruling TR 95/25 outlines the implications flowing from the decision of the Full Federal Court in FC of T v Roberts; FC of T v. Smith 92 ATC 4380 ; (1992) 23 ATR 494 ( Roberts and Smith ). Whether a loss has a sufficient nexus to the gaining or producing of assessable income is a question of fact and circumstances. However, the general principles for determining interest deductibility set out in Taxation Ruling TR 95/25 provide the following guidance for present purposes (at paragraph 3): The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income … The test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances. The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. However, regard must be had to all the circumstances, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest. … A rigid tracing of the borrowed money will not always be necessary or appropriate (e.g., where the borrowing finances the replacement of funds withdrawn from the business by a person entitled to be paid those funds). In such cases the relevant question is whether borrowed funds are being used to replace another source of funding for business purposes. Refinancing principle To demonstrate that a sufficient nexus exists between a loss made from interest coupons paid on borrowings and the gaining or producing of assessable income, the 'refinancing principle' in Roberts and Smith may be used. Paragraphs 12 to 17 of Taxation Ruling TR 95/25 consider the 'refinancing principle' in relation to companies. A loss made from interest coupons may be deductible under the 'refinancing principle' where borrowed funds are used to fund a repayment of share capital or a realised profit reserve to the shareholders in circumstances where the repaid capital or realised profit reserve was employed as capital or working capital in the business carried on by the company for the purpose of deriving assessable income. The 'refinancing principle' is applied to the income tax consolidated group as if it were a single entity. Under the single entity rule contained in section 701-1 the subsidiary members of a consolidated group are taken to be parts of the group's head company for the purpose of working out the head company's liability to income tax or determination of a loss. In this context, the money or property used by the subsidiary members in the business to gain or produce the head company's assessable income should be treated as capital or working capital of the head company. The 'refinancing principle' may apply where certain shareholders' equity (i.e. share capital or realised profit reserve) of the head company employed as capital or working capital in the business of the head company for the purpose of deriving assessable income is replaced by borrowed funds. In the context of Roberts and Smith , where borrowed funds are used by the head company of the consolidated group to buy-back its shares on-market, those funds are effectively seen as a replacement for a source of funding (i.e. shareholders' equity) that was previously used in the business of the head company. Accordingly, to the extent the borrowed funds are replacing share capital or a realised profit reserve employed as capital or working capital in the business carried on by the head company for the purposes of gaining or producing assessable income, the head company is entitled to a deduction under subsection 230-15(2) for any loss made from interest coupons paid on those funds used in the business to gain or produce assessable income. Company A will first use the cash raised from the borrowings to fund Company A's on-market share buy-back. After the borrowed funds have been used, Company A's cash reserves will fund the remainder of the proposed on-market share buy-back. In the context of Roberts and Smith , the borrowings are effectively seen as a replacement of the shareholders' equity of the Company A TCG. The shareholders' equity of the Company A TCG consists of share capital and realised profit reserves. This amount can be considered to be (partly) replaced by the borrowings. The Company A TCG employs its shareholders' equity: • as capital and working capital in the Australian business carried on by the Company A TCG to gain or produce assessable income; and • as business investments in foreign subsidiaries to derive non-assessable non-exempt (NANE) income under former section 23AJ of the ITAA 1936 or new section 768-5. Conclusion Accordingly, to the extent the proposed borrowings will be replacing (part of) the Company A's shareholders' equity employed as capital or working capital in the business carried on by the Company A TCG for the purpose of gaining or producing assessable income, Company A (as head company of the Company A TCG) will be entitled to claim a deduction under subsection 230-15(2) for any loss made from interest coupons paid on those funds used in the business of the Company A to gain or produce assessable income. Company A (as the head company of the Company A TCG) is not entitled to a deduction under subsection 230-15(2) to the extent the proposed borrowings will be replacing (part of) the Company A's shareholders' equity used in the business carried on by the Company A TCG for the purposes of deriving NANE income under former section 23AJ of the ITAA 1936 or new section 768-5. Refer to question 2 whether in that case Company A (as head company of the Company A TCG) will be entitled to a claim a deduction under subsection 230-15(3) in relation to the interest coupons paid on those funds. Deduction under subsection 230-15(3) As an 'Australian entity' Company A (as the head company of the Company A TCG) is entitled to a deduction under subsection 230-15(3) for a loss from a financial arrangement if: • the Company A TCG makes the loss in deriving income from a foreign source; and • the income is non-assessable non-exempt income under section 768-5 (or former section 23AJ of the ITAA 1936), or section 23AI or 23AK of the ITAA 1936; and • the loss is, in whole or in part, a cost in relation to a debt interest the Company A TCG issues that is covered by paragraph 820-40(1)(a). As discussed in question 1, the borrowings will satisfy the definition of a 'financial arrangement' under subsection 230-45(1) and the borrowings are taken to be debt interests under Division 974. Any loss that is referable to the obligation to pay interest coupons on the borrowings is a cost covered by paragraph 820-40(1)(a). In the context of Roberts and Smith (as discussed under question 1), the borrowings will be effectively replacing (part of) the Company A TCG's shareholders' equity used in the business carried on by the Company A TCG for the purpose of deriving NANE income under former section 23AJ of the ITAA 1936 or section 768-5 from its foreign subsidiaries. Where a dividend has not actually been derived under former section 23AJ of the ITAA 1936 or section 768-5, there must be a reasonable expectation, together with a more than theoretical potential, for such a dividend to be paid by each of the foreign subsidiaries of the Company A TCG. The Company A TCG's investment in foreign subsidiaries has produced, and is expected to produce, foreign income, which is treated as NANE under former section 23AJ of the ITAA 1936 or, in respect of dividends made after 16 October 2014, section 768-5. This is required to demonstrate a sufficiently clear nexus, at the time that any loss is made from interest coupons paid on the borrowings, between the relevant loss and either the production of an actual section 768-5 dividend or an expected section 768-5 dividend (consistent with Taxation Determination TD 2009/21 in relation to section 23AJ dividends). Accordingly, to the extent the proposed borrowings will be replacing (part of) the Company A's shareholders' equity employed in the business of the Company A TCG to derive NANE income under former section 23AJ of the ITAA 1936 or new section 768-5, Company A (as the head company of the Company A TCG) will be entitled to claim a deduction under subsection 230-15(3) for any loss made from interest coupons paid on those funds used in the business to derive NANE income under former section 23AJ of the ITAA 1936 or new section 768-5.

Reasons for decision: All legislative references in this Ruling are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.