The Australian Taxation Office (ATO) has issued a draft taxation ruling TR 2012/D5 'Income tax: debt and equity interests: when is a public unit trust in a stapled group a connected entity of a company for the purposes of paragraph 974-80(1)(b) of the Income Tax Assessment Act 1997' which will significantly impact the tax consequences for capital raisings (past and present) for stapled groups.
According to the ATO, monies advanced between stapled entities may not qualify as 'debt' for tax purposes, where the 'economic group' arrangements result in the stapled entities being 'connected entities' for tax purposes. This will mean that (provided all the other requirements in section 974-80 of the Income Tax Assessment Act 1997 are satisfied), that the section may apply to re-characterise the 'debt' as 'equity' for tax purposes. In these circumstances, monies lent by a public unit trust to a company that is part of the stapled group may be treated as equity (and not debt) for tax purposes and accordingly any 'interest' deductions will be denied to the company borrower.
The tax treatment of distributions to investors will also be affected, including withholding tax rates for non-resident investors. Whereas 10% withholding tax applies to distributions of interest, 30% withholding tax applies to ‘dividend’ distributions, subject to any tax treaty relief.
The ruling once finalised is proposed to have retrospective effect – that is, it will apply to years of income commencing both before and after the date on which the final ruling is issued.
TR 2012/D5 will apply to arrangements where:
- shares in a company (or a trust that is taxed like a company) are stapled to units in a public unit trust (together the stapled group)
- the stapled group undertakes a capital raising or borrowing to raise funds to be used in the business conducted by the company, and
- a significant portion of the funds received as part of the capital raising or borrowing is contributed to the public unit trust which in turn advances the monies raised to the stapled company (or its subsidiaries) in the form of ‘debt’ for tax purposes.
Given the very broad nature of the arrangements described above, we consider that this ruling will potentially apply to most stapled groups in the Australian market – typically in the property and infrastructure sectors.
Capital raisings using a stapled structure
A stapled group is a relatively common business structure in Australia. Generally, this structure comprises a company (or a public trading trust that is taxed like a company) with its shares (or units) ‘stapled’ to units in a widely held or public trust. The company usually conducts an active business and the public unit trust is a passive investment vehicle, which can include providing finance to the company. The stapled entities may also be listed on the Australian Stock Exchange.
Generally, the stapled group raises funds for the business by issuing the stapled securities to investors. The funds subscribed by investors are mainly contributed to the public unit trust and then lent by the trustee to the company. Alternatively, the funds are used to subscribe for another debt interest in the company, such as redeemable preference shares.
The trustee uses the returns paid on the debt interest to fully or partially fund (pre-tax) distributions to the stapled security holders. Generally, the public unit trust distributions are paid instead of company dividends. As a consequence, the stapled security holders are, in substance, receiving (pre-tax) returns on their equity investment in the stapled group by way of trust distributions funded by the company’s interest payments to the stapled public unit trust.
How does 974-80 apply to re-characterise debt as equity?
Section 974-80 of the Income Tax Assessment Act 1997 is an integrity provision which allows a 'debt interest' between 'connected entities' to be re-classified as an equity interest for tax purposes where there is an equity return to an ultimate recipient (eg, the investors in the public unit trust) that is in substance or effect contingent on the performance of the company or a connected entity of the company. Where the 'debt interest' is re-characterised as equity for tax purposes, then no interest or debt deductions will be available to the company borrower.
Who is a connected entity?
The entities in a stapled group may be 'connected entities' where either has control or sufficient influence over the other. On the basis that 'control' is unlikely to exist, the key test is whether there is sufficient influence between the entities in the stapled group.
What is Sufficient Influence?
The public unit trust or the company (or its directors) will be considered to be sufficiently influenced by another entity or entities where they are 'accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the other entity or other entities (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts)'.
According to the ATO, the mere fact that the public unit trust is stapled to the company does not in itself lead to a conclusion that one would influence the other. However, the ATO considers that this fact together with other substantive evidence including the terms of any relevant agreements or constituent documents (for example the Stapling Deed and security arrangements as part of any external borrowings), as well as the role of the public unit trust as financier for the company may lead to a conclusion that the company sufficiently influences the public unit trust.
The draft ruling provides numerous examples of drafting in a stapling deed that may lead the ATO to conclude that one member of the stapled group sufficiently influences the other. Some key examples include:
- the trustee or the company must enter into any arrangement or consider doing anything at the request or under the direction of the other in particular in respect of:
- lending money or providing financial accommodation
- guaranteeing any loans or
- issuing any forms of securities
- neither the trustee or company may, without the prior consent of the other:
- undertake a placement or rights issue
- declare a distribution
- both members of the stapled group must co-operate and consult with the other in respect to:
- announcing or paying a distribution or dividend
- acquiring or selling an asset or
- borrowing or raising money.
While the existence of such clauses may not in itself cause the a member of the stapled group to be sufficiently influenced by the other, this along with the other factors (such as that the public unit trust must provide funds to the company or is solely responsible for financing the stapled group) may lead to such a conclusion.
The ATO also considers that where members on the board of the trustee for the public unit trust are also members of the board for the company, then although they have separate and distinct fiduciary obligations, because the interests of the public unit trust and company are aligned, then this may lead to a conclusion that the public unit trust sufficiently influences the company (or vice versa).
Further, the ATO also considers that where the trustee of the public unit trust and the manager of the company is the same person/entity (albeit acting in two different capacities) then consideration will need to given to whether this person/entity sufficiently influences both the public unit trust and company.
View an example from the draft ruling which illustrates how the ATO is likely to approach these issues.
Likely implications – some initial thoughts
Banks and other financial institutions
- External lenders and financial institutions will be concerned to confirm whether any borrowings may be used to provide a cross staple loan or advance and whether the stapled entities will likely qualify as 'connected entities'. In addition, the stapled groups may be reluctant to provide security over assets held by the company where the public unit trust is borrowing since this is one factor that may suggest the entities are connected entities for tax purposes.
Property trusts and infrastructure funds
- The draft ruling does not address loan arrangements from a company to a public unit trust as part of a stapled arrangement. In these circumstances, section 974-80 of the Income Tax Assessment Act 1997 cannot apply and the company will in any case pay company tax on the interest income received.
- Although the examples in the draft ruling suggest that the public unit trust is predominantly a 'finance trust', the approach outlined may have equal application where the public unit trust is (say) a property or infrastructure trust and the funds raised are predominantly contributed to the public unit trust and then used by the trustee to acquire a debt interest in the company.
Need to review the constituent documents and lending arrangements
- It will be necessary to confirm that all the requirements in section 974-80 are satisfied, including that the stapled entities are 'connected entities'.
- The terms of the stapling deed (or any shareholder agreements) and other related constituent documents (including the borrowing terms and related security arrangements) will be critical to determine whether the entities are connected entities for these purposes. Stapled groups should review and consider their constituent documents, loan agreements, security arrangements, etc to confirm whether the stapled entities will likely qualify as connected entities.
- This is ultimately a question of fact and it will be necessary to consider all the facts and surrounding circumstances.
Tax consequences for investors – especially non-resident investors
- The tax treatment of distributions to investors will also be affected, including withholding tax rates for non-resident investors. Whereas 10% withholding tax applies to distributions of interest, 30% withholding tax applies to 'dividend' distributions, subject to any tax treaty relief.
ATO approach to the de facto 'control' test is very broad
- This is one of the few indications from the ATO of their 'broad' understanding of the meaning of sufficient influence in the 'associate' tests. This is potentially much broader than say a 'de facto' control test and it is not clear that this was the intention of the Parliament.
- The concept of sufficient influence and de facto control as part of the associate test has much wider application under the Tax Act, (including for the purposes of applying the thin capitalisation tests). The ATO approach potentially disregards the legal powers, duties and fiduciary obligations of trustees, directors and managers.
Comments to the ATO
The ATO has invited comments on the draft Ruling by 7 September 2012. Minter Ellison will be making a submission. Please contact us if you would like to discuss or understand any of these issues further or raise any additional concerns.