Private ruling: Debt interests
Published: August 2013
Ruling period: year ending 30 June 2006 | year ending 30 June 2007 | year ending 30 June 2008 | year ending 30 June 2009 | year ending 30 June 2010 | year ending 30 June 2011 | year ending 30 June 2012 | year ending 30 June 2013
Date scheme commenced: year ending 30 June 2006

Ruling: Q1: Will the intra-group loan made by Company X to the taxpayer be characterised as a debt interest for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes, the intra-group loan will be characterised as a debt interest for the purposes of Division 974 of the ITAA 1997.

Relevant facts and circumstances: Company X (the Lender) is the ultimate holding company of the X group of companies (the X Group). The X Group is not a consolidated group for income tax purposes. The Lender lent money to the various member of the X Group pursuant to various advances (intra-group loans). The taxpayer (the Borrower) is a member of the X Group. The Borrower is a wholly owned subsidiary of the Lender. A primary purpose of the Loan Facilities was the on-lending by the Lender of the borrowed funds to entities within the X Group including the Borrower. The intra-group loan was not documented in the form of a written loan agreement. Evidence of the existence of an unwritten loan contract between the Lender and the Borrower, and the terms of each contract, was provided in the form of: (a) Copies of statutory declarations from directors; (b) financial reports of the Lender and the Borrower for the relevant income years confirming that interest payable by the Borrower has been credited in their accounts. The loan is unsecured. The Lender had given loan to the Borrower on an at call basis. The intra-group loan is repayable on or within a reasonable time of a demand being made by the Lender. There is no fixed term. However, statutory declarations have been provided by Directors stating what they consider were the terms of the loan. The terms of the intra-group loan has not been varied since it was made. Since the original amounts were advanced to the Borrower, the balances of the loans have varied over time. Loan account balances showing the borrowings of the subsidiary entities including the Borrower from the Lender were detailed. The Borrower loans are recorded in partnership accounts. The statutory declaration shows the initial borrowing and loan balance. The interest rate is determined from time to time by the Lender as follows: (i) interest accrues daily on the amount of the intra-group loan outstanding and is payable by the Borrower to the Lender annually and, if unpaid, the interest is capitalised and increases the balance outstanding of the intra-group loan; (ii) interest payable by the Borrower is based upon the Borrower's proportionate share of the total of all intra-group loans and the total interest is intended to be at least equal to the to the interest and borrowing fees the Lender is required to pay to financial institutions pursuant to the Loan Facilities; and (iii) the interest rate for the intra-group loans is calculated by the Lender annually at a rate which is intended to ensure that interest payments the Lender receives from the Borrowers in relation to the intra-group loans is at least equal to the interest and borrowing fees the Lender is required to pay the financial institutions pursuant to the Loan Facilities. (iv) The interest payable by the Lender on its borrowings from its external financiers under the loan facility is the rate of interest used as the basis for calculating the interest payable by the Borrower, although the actual interest charged to the Borrower is marginally higher than that payable by the Lender to take account of the borrowing fees the Lender is required to pay. (v) The interest payable by the Lender on a portion of its borrowings under the loan facilities is calculated at a floating rate, by reference to the Australian Bank Bill Swap Bid Rate (BBSY). This floating rate is in turn, used as part of the formula for determining the rate of interest charged on the intra-group loan from the Lender to the Borrower. (vi) The actual interest rate charged to the Borrower is a 'blended' rate, based on a combination of the fixed and floating BBSY rates charged to the Lender under the loan facility, which fluctuates over time and remains on issue notwithstanding that the balance of the intra-group loan will fluctuate over time in line with movements in BBSY. Consistent with the loan terms set out above, in each financial year since the intra-group loan was made, the Lender has endeavoured to calculate the interest payable on the intra-group loan and the amount of interest has been capitalised and recorded in the books of account of the Lender and the Borrower. This is confirmed by the financial reports, balance sheets and profit and loss statements. The interest on-charged from the Lender to the Borrower, for each financial was provided. The obligation of the Borrower to pay interest on the intra-group loan is not contingent on any event, condition or situation. Neither the interest rate nor the payment of interest is at the discretion of the Borrower. The Lender has borrowed funds from financial institutions pursuant to the arrangements (Loan Facilities). It was a condition precedent of the Loan Facilities that various securities be provided to secure the amounts to be borrowed by the Lender. The Borrowers provided various mortgages and charges to secure the Loan Facilities. The Borrower has provided blended interest rate and present value calculations.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 995-1. | Income Tax Assessment Act 1997 Section 974-20. | Income Tax Assessment Act 1997 Section 974-150. | Income Tax Assessment Act 1997 Section 974-75. | Income Tax Assessment Act 1997 Section 974-5. | Income Tax Assessment Act 1997 Section 974-70. | Income Tax Assessment Act 1997 Section 974-15. | Income Tax Assessment Act 1997 Section 974-135. | Income Tax Assessment Act 1997 Section 974-35. | Income Tax Assessment Act 1997 Section 974-155. | Income Tax Assessment Act 1997 Section 974-80. | Income Tax Assessment Act 1997 Section 960-135. | Income Tax Assessment Act 1936 Section 318. | Income Tax Assessment Act 1997 Subsection 974-15(1). | Income Tax Assessment Act 1997 Subsection 974-20(1). | Income Tax Assessment Act 1997 Section 974-35. | Income Tax Assessment Act 1997 Section 974-130. | Income Tax Assessment Act 1997 Section 974-135. | Income Tax Assessment Act 1997 Section 974-160. | Income Tax Assessment Act 1997 Section 974-40.

Reasons for decision: Detailed Reasoning - Debt interest under Subdivision 974-B of the ITAA 1997: Subsection 974-15(1) of the ITAA 1997 provides that a scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) of the ITAA 1997 in relation to the entity. Broadly, subsection 974-20(1) provides that the following conditions must be satisfied for a scheme to give rise to a debt interest in relation to an entity: (a) The scheme is a financing arrangement for the entity; and (b) The entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme; and (c) the entity has, or the entity and a connected entity of the entity each has, an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities; and (d) It is substantially more likely than not that the value provided will be at least equal to the value received; and (e) The value provided and the value received are not both nil. (a) Is there a scheme? The term scheme for the purposes of Division 974 is defined in section 974-150 of the ITAA 1997. The definition of a scheme in section 974-150 is given the meaning in section 995-1 of the ITAA 1997. Section 995-1 defines a scheme as any arrangement; or any scheme, plan, proposal, action course of action or course of conduct, whether unilateral or otherwise. The arrangement being the intra group loan from the Lender to the Borrower constitutes a scheme for the purposes of Division 974 of the ITAA 1997. Is the scheme a financing arrangement? A scheme is a financing arrangement as defined in paragraph 974-130(1)(a) of the ITAA 1997, if it is undertaken to raise finance for the entity. The relevant entity is the Borrower under the relevant intra-group loan. The purpose of the intra-group loan was to raise finance for the Borrower. Various borrowers (collectively) provided the mortgages and charges needed to secure the loan facilities pursuant to which the Lender borrowed funds that could then be (and have been) on-lent to the Borrower by way of the intra-group loan. The Borrower intra-group loan will be a financing arrangement as defined as it will be a scheme undertaken to raise finance for the Borrower. (b) Does the entity or connected entity receive a financial benefit under the scheme? The term financial benefit is defined in paragraph 974-160(1)(a) of the ITAA 1997 to include 'anything of economic value'. On the terms of the scheme the Borrower will receiving funding from the Lender through advances of money. The Borrower will therefore receive a financial benefit under the scheme. (c) Does the entity have an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities? The term effectively non-contingent obligation (ENCO) is defined in section 974-135 of the ITAA 1997. Subsection 974-135(1) of the ITAA 1997 provides that there is an ENCO to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action. Subsection 974-135(3) of the ITAA 1997 provides that an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity) other than the ability or willingness of that entity to meet the obligation. In addition, subsection 974-135(4) provides that the right of the holder of an interest that will or may convert into an equity interest in the entity will not of itself make the issuers obligation to repay the investment not non-contingent. The relevant financial benefits that fall for consideration under section 974-135 of the ITAA 1997 in relation to the loans are the company's obligations to: (i) repay the principal amounts advanced under the loan; and (ii) pay interest on the loans. The issue of whether any of these obligations amount to an effectively non-contingent obligation to provide a financial benefit is considered below. (i) Obligation to repay the principal On the day the first advance was made to the Borrower, the Borrower had an obligation to provide the following financial benefits to the Lender: (i) interest payable annually or, if not paid, capitalised; and (ii) repayment of the loan (including any capitalised interest) on demand on or within a reasonable time of demand being made by the Lender. The intra-group loan is considered to be an at call loan. The Borrower has provided statutory declarations that these obligations were not contingent upon any event, condition or situation other than the ability or willingness of the Borrower to meet the obligation. An at call loan is one where the creditors right to sue for recovery of principal arises as soon as the loan is made and it is the intention of the parties that the principal will in fact be repaid at a date of the Lenders choosing. The Borrower has an effectively non-contingent obligation to repay the principal amounts advanced under the intra-group loan. Having regard to the pricing, terms and conditions of the scheme, it is considered that the Borrower has an effectively non-contingent obligation to provide financial benefits to the Lender because of its nature. (d) Is it substantially more likely than not that the benefit provided will at least equal the benefit received? The fourth criterion under the debt test that must be satisfied is that the value of the financial benefits provided, or to be provided, by the Borrower must be at least equal to the value received, or to be received, by the Lender (paragraph 974-20(1)(d) of the ITAA 1997). Section 974-35 of the ITAA 1997 sets out the manner in which the value of a financial benefit to be provided or received under the scheme is to be calculated. Paragraph 974-35(1)(a) provides that the value of a financial benefit to be provided or received is to be calculated in nominal terms if the performance period ends no later than 10 years after the interest arising from the scheme is issued or, in present value terms if the performance period must, or may, end more than 10 years after the interest arising from the scheme is issued. Subsection 974-35(3) of the ITAA 1997 defines the performance period as: the period within which, under the terms on which the interest is issued, the effectively non-contingent obligations of the issuer, and any connected entity of the issuer, to provide a financial benefit in relation to the interest have to be met. The Borrower is under an effectively non-contingent obligation to provide periodic returns on the intra-group loan. The intra-group loan does not have a defined term. In addition there is nothing in the pricing, terms or conditions of the scheme details as provided that would lead to the conclusion that subsection 974-40(2) of the ITAA 1997 would apply to suggest that the Borrower is under an effectively non-contingent obligation to exercise its discretion to terminate the scheme by causing any event to occur. Having regard to these factors and the operation of subsection 974-35(2) of the ITAA 1997 the intra-group loan will have a performance period that is perpetual. As a consequence, net present values must be used to value the financial benefits that the Lender has an effectively non-contingent obligation to provide. Section 974-50 of the ITAA 1997 sets out the manner in which financial benefits are to be valued in present value terms, and the assumptions that are required to be made. Under section 974-50, the present value of each financial benefit is to be determined separately (subsection 974-50(2) of the ITAA 1997) and the value of a financial benefit is to be calculated assuming that all amounts paid by the entity in respect of the test interest are paid at the earliest time when the entity becomes liable to pay them (subsection 974-50(3) of the ITAA 1997). Accordingly, in accordance with section 974-35(5) of the ITAA 1997, for the purpose of calculating the financial benefits provided by the Borrower, that the value of interest payments (financial benefits) to be provided under the intra-group loan should be calculated using the blended interest rate that was applicable under the loan facilities at the time the intra-group loans were made. This is on the basis that the intra-group loan was issued at that time and remain on issue notwithstanding that the balance of the intra-group loan may have fluctuated (upwards or downwards) over time as per section 975-55 of the ITAA 1997. Subsection 974-50(4) of the ITAA 1997 provides a formula for valuing financial benefits in present value terms: Amount or value of financial benefit in nominal terms [1 + Adjusted benchmark rate of return] n where: adjusted benchmark rate of return is 75% of the benchmark rate of return on the test interest. n is the number of years in the period starting on the day on which the test interest is issued and ending on the day in which the financial benefit is to be provided. If the period includes a part of the year, that part is to be expressed as the fraction: Number of days in that period Number of days in the year year means a period of 12 calendar months. As the intra-group loan is only repayable on demand, the performance period for the intra-group loan may end more than ten years after the issue of the debt interest. In this case, n approaches infinity because the intra-group loan is perpetual. This means that the value of the financial benefits provided to the Borrower must be calculated in present value terms in accordance with the formula in subsection 974-50(40) of the ITAA 1997. Paragraph 2.193 of the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 provides that: where the value of the financial benefit is the same each year and n approaches infinity, the formula in subsection 974-50(4) of the ITAA 1997 can be expressed as: The amount or value of financial benefit in nominal terms adjusted benchmark rate of return As defined by subsection 974-50(4) of the ITAA 1997, the 'adjusted benchmark rate of return' is 75% of the benchmark rate of return. The benchmark rate of return is defined in section 995-1 of the ITAA 1997 to have the meaning given by section 974-145 of the ITAA 1997. Under this formula the present value of the financial benefit provided by the Borrower will always be at least equal to the value of the financial benefit received if interest on the intra-group loan in respect of the Borrower is paid at a rate equal to or more than 75% of the 'benchmark rate of return'. Subsections 974-145(1) and (2) of the ITAA 1997 provide: (1) The benchmark rate of return for an interest (the test interest ) in an entity is the annually compounded internal rate of return on an ordinary debt interest that: (a) is issued, immediately before the test interest is issued, by the entity, or an equivalent entity, to an entity that is not a connected entity; and (b) has a comparable maturity date; and (c) is in the same currency; and (d) is issued in the same market; and (e) has the same credit status; and (f) has the same degree of subordination to debts owed to the ordinary creditors of the issuer. (2) If there is no interest that satisfies subsection (1), the benchmark rate of return for the test interest is the annually compounded internal rate of return on an interest that is closest to the test interest in the respects referred to in that subsection (adjusted appropriately to take account of the differences between that interest and the test interest). An ordinary debt interest is defined in section 974-140 of the ITAA 1997 as: (1) A *debt interest arising from a scheme is an ordinary debt interest if none of the obligations under the scheme is in substance or effect *contingent on the economic performance of: (a) the issuer of the interest; or (b) a connected entity; or (c ) a part of the operations of the issuer or a connected entity. (2) The regulations may specify rules for determining whether a *debt interest is an *ordinary debt interest. Subsection 974-145(1) of the ITAA 1997 requires identifying the comparable interest rate on an 'ordinary' loan to the Borrower or equivalent entity where the loan has the features in paragraphs 974-145(1)(b) to (f). The applicant is not aware of any such loans made to the Borrower. The Borrowers' only borrowings are the intra-group loan. Section 974-145(1) of the ITAA 1997 allows the entity to look at the interest rate on equivalent borrowings by equivalent entities at that time. If no equivalent debt can be found, sub-section 974-145(2) states that if no equivalent debt can be found, than an ordinary debt interest which is the next closest interest in respect to those characteristics be found and that is then used as the benchmark rate of return. Subsection 974-145(2) of the ITAA 1997 permits the Borrower to identify an interest which is closest to the test interest (with adjustments for differences in the factors outlined in section 974-145(1). The Borrower has identified the loan facility for the Lender as being an ordinary debt interest that is closest to the test interest. The current loan facility is closest to the test interest when regard is given to the following factors: § The current intra-group loan has no fixed term however the lending facility appears to have terms of either around 10 years (Facility 1 and 2), 2 years (Facility 3) or 1 year (Facility 4); § The interest rate for the loan facility differs according to the type of facility (i.e. either Facility 1, 2; 3 or 4 and can either be a fixed rate advance or floating rate advance. The loan facilities from financial institutions to the Lender are ordinary debt interests that have the features identified in subsection 974-145(1) of the ITAA 1997 and on that basis that the benchmark rate of return for the intra-group loan facility is the same as the arms length interest rate charted under the loan facilities. The Loan Facility and the intra-group loan exhibit the features in paragraph 974-145(1)(b) to (f) of the ITAA 1997 when they are considered in the above context. That is the corporate group has borrowed funds from the financial institutions where security has been provided by each entity in that group. The intra-group loan and Loan Facilities have comparable maturity dates per paragraph 974-145(1)(b) of the ITAA 1997 because when the loan facilities are required to be repaid, the Lender will demand repayment of the intra-group loan at the same time as those funds are likely to be needed by the Lender to repay the loan facilities. On the basis of the terms of the intra-group loan, the interest payable by the Borrower in respect of its 'test interest' will be at least equal to the benchmark rate of return and that pursuant to the formula in subsection 974-50(4) of the ITAA 1997. Having regard to the factors set out in paragraphs 974-145(a)-(f) of the ITAA 1997 and the requirements to make adjustments to achieve a comparable interest under subsection 974-145(2) of the ITAA 1997, it is considered that the adjustments made by the Borrower satisfies the requirements of these provisions. Based on the calculations provided by the Borrower the value of financial benefits it is substantially more likely than not that the benefit to be provided (calculated in present value terms) will at least be equal to the benefit to be received. | Detailed Reasoning - (e) both the value provided and the value received are not both nil.: The value provided and the value received are not both nil and this requirement is satisfied. | Detailed Reasoning - Conclusion: The requirements of the debt test will be satisfied in relation to the scheme and as a consequence the scheme gives rise to a debt interest pursuant to section 974-15 of the ITAA 1997. We have not considered the equity test in section 974-70 as the tiebreaker rule in paragraph 974-70(1)(b) of the ITAA 1997 provides that a scheme will give rise to an equity interest if it is not otherwise characterised as a debt interest.

Does Part IVA apply to this ruling?: Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable. | We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part. | If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply. | For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.