2015 FINANCIAL SERVICES
TAXATION CONFERENCE
Update on Capital Management Issues
Written and presented by:
Tim Kyle
Director
Greenwoods & Herbert Smith Freehills
National Division
18-20 February 2015
Surfers Paradise Marriott Resort & Spa
© Tim Kyle, Greenwoods & Herbert Smith Freehills – February 2015
Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute.
The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The
material and opinions in the paper should not be used or treated as professional advice and readers should
rely on their own enquiries in making any decisions concerning their own interests.
510501316
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Update on Capital Management Issues
CONTENTS
1
Introduction ....................................................................................................................................4
2
Capital management in the financial services sector ................................................................5
3
2.1
What is capital management?...................................................................................................5
2.2
Overview of the recent CM activity ...........................................................................................5
2.3
Themes that emerge .................................................................................................................6
2.4
The likely future direction of CM activity ...................................................................................9
2.4.1
Recommendation 1: ADI capital levels ..............................................................................9
2.4.2
Recommendation 2: narrow bank mortgage risk weight differences...............................10
2.4.3
Recommendation 3: ADI loss absorbing and recapitalisation capacity (TLAC) ..............11
2.4.4
Conclusion .......................................................................................................................12
Hybrids ..........................................................................................................................................13
3.1
Overview .................................................................................................................................13
3.2
Regulatory capital requirements .............................................................................................13
3.3
Snapshot of the Australian FS hybrids market .......................................................................13
3.4
Tax issues associated with hybrids.........................................................................................15
3.5
Board of Taxation debt/equity discussion paper .....................................................................16
3.6
Section 215-10 ........................................................................................................................17
3.7
BEPS.......................................................................................................................................18
3.8
A regulatory capital “haircut”? .................................................................................................20
3.8.1
Tier 2 securities................................................................................................................20
3.8.2
Tier 1 instruments ............................................................................................................24
3.9
Blank’s case and non-share equity .........................................................................................24
3.10
Financing regulatory capital of a subsidiary ........................................................................26
3.11
Available frankable profits ...................................................................................................26
3.11.1
The relevant provisions....................................................................................................26
3.11.2
Corporate law changes ....................................................................................................28
3.12
The ATO ruling experience .................................................................................................29
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Update on Capital Management Issues
Returning funds to investors ......................................................................................................31
4.1
MGL distribution of SYD securities .........................................................................................31
4.1.1
Context.............................................................................................................................31
4.1.2
Overview of tax issues .....................................................................................................32
4.1.3
The dividend/capital split .................................................................................................32
4.1.4
The nominee structure.....................................................................................................34
4.1.5
TFN withholding from an in specie distribution................................................................35
4.1.6
Share consolidation .........................................................................................................35
4.2
Share capital tainting...............................................................................................................35
4.2.1
Context.............................................................................................................................35
4.2.2
The provisions..................................................................................................................36
4.2.3
Things we are relatively certain about .............................................................................37
4.2.4
Some potentially problematic areas ................................................................................38
4.3
Observations ...........................................................................................................................38
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1 Introduction
Australian resident corporates in the financial services (FS) sector have been actively engaged in
capital management (CM) activities in recent years.
By way of example, there have been significant issues of hybrid capital. The Australian Prudential
Regulation Authority (APRA) regulatory and income tax issues associated with these raisings have
already been comprehensively dealt with at the 2013 Financial Services Conference in the Tricia HoHudson and Tony Frost paper entitled “Capital management of financial institutions and the related
tax issues” (Ho-Hudson/Frost paper).
This paper:
•
identifies themes emerging from the CM activities of FS participants over the last two
financial years;
•
provides an update on key Australian income tax issues associated with hybrid capital
raisings;
•
provides observations on Australian income tax issues associated with other (ie, non-
•
hybrid) CM activities; and
looks at some of the factors that will shape the CM activities of FS participants in the
coming years and comments on the associated Australian income tax issues.
All legislative references in this paper are to the provisions of the Income Tax Assessment Act 1936
(ITAA 36) and the Income Tax Assessment Act 1997 (ITAA 97) (collectively the Tax Act), unless
indicated otherwise.
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2 Capital management in the financial services sector
2.1 What is capital management?
The CM activities considered in this paper include both:

raising funds from investors; and

returning funds to investors.
Importantly, the CM concept covers most transactions reflected in the debt and equity sections of a
company’s balance sheet – and is not confined to transactions involving the raising/return of
share/non-share capital.
That is, the CM concept includes:

raising funds by way of issue of ordinary shares, hybrids (such as convertible preference
shares (CPS), Additional Tier 1 equity notes, Tier 2 subordinated debt) as well as ordinary (ie,
non-hybrid) debt; and

returning funds by way of payment of dividends/non-share dividends, interest, returns of
capital/non-share capital and buy-backs of shares/non-share equity.
The dollar amounts involved in CM in the FS sector are significant. For example, each year billions of
dollars of existing hybrids are “retired” and refinanced with replacement capital raisings. As a result,
CM is an increasingly specialised and important discipline. Most FS participants have dedicated and
well-resourced CM teams within their Treasury group. Their role is primarily to manage:

the level of capital; and

the mix of capital.
Typically, these teams develop longer term views about CM needs and plan capital raisings and other
CM activities quite far in advance, while retaining the flexibility to respond quickly to emerging
regulatory and market opportunities and challenges.
2.2 Overview of the recent CM activity
So, what have Australian participants in the financial services sector been up to by way of CM
activities in recent years?
1
The following APRA prepared chart highlights changes to the banks’ funding mix over time.
1
L Berkelmans and A Duong, Developments in Banks’ Funding Costs and Lending Rates, RBA Bulletin, March Quarter 2014:
http://www.rba.gov.au/publications/bulletin/2014/mar/bu-0314-8a.html
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As can be seen, the vast bulk of bank funding comes from the issue of debt instruments. Further
comments on bank debt funding are set out in theme #4 below.
2.3 Themes that emerge
The themes identified below are gleaned from financial accounts for the two most recently completed
financial reporting years.
The “universe” of FS participants for the purposes of this section comprises the ASX/S&P 200
2
Financials (ex-AREIT) Index (XXJ) . Broadly, it covers the Banks, Diversified Financials and
Insurance GICS industry classifications:
As readers would appreciate, it is more difficult to obtain information on the Australian CM activities of
foreign based participants in the Australian FS sector.
A number of themes can be observed.
Theme #1: massive amounts of regular dividends
The big 4 banks in particular have paid significant amounts of dividends – over $41 billion franked
dividends during the relevant period.
This is in the context of a trend of steadily increasing bank dividends over the last decade.
The graph below was prepared from publicly available information.
2
http://au.spindices.com/indices/equity/sp-asx-200-financial-x-a-reit-sector
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Total Big 4 Bank Dividends
1200
1000
800
600
Cents per share
400
200
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Theme #2: significant issuance of hybrid regulatory capital
The big 4 banks and Macquarie in particular have been actively issuing hybrids.
Hybrids issues into the retail markets since the start of the 2013 financial year exceed $15 billion.
Additional amounts have been issued into wholesale markets, but the amounts are less transparent.
However, importantly, total hybrids on issue have not increased by that amount. Rather, this cohort
also retired significant amounts of existing hybrids during the same period – understood to be around
$6.5 billion.
This means that the net increase in hybrid issuance by this cohort was around $8.5 billion. A
significant amount nonetheless.
Significantly, a number of other FS participants in both the banking and insurance fields commenced
issuing hybrids in earnest during this period. Our research indicates that over $3 billion was issued by
these players.
More details on hybrid issues during this period are set out in section 3.
Theme #3: almost no change to total issued ordinary shares
In striking contrast to the position regarding hybrids, FS participants issued only relatively small
numbers of ordinary shares – and those issues were largely confined to:
•
employee share and option plans (which typically don’t involve a significant inflow of
•
cash to the issuer – so don’t meaningfully increase its regulatory capital); and
dividend reinvestment plans (DRIPs).
Banks in particular have significant DRIPs. However, what is interesting is that many DRIPs involved
the recycling of shares already on issue (ie, DRIP participants are supplied with shares that have
been purchased on market, rather than being issued with shares). Moreover, even where they issued
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ordinary shares under their DRIPs, ANZ and NAB bought back corresponding amounts of ordinary
shares on market in the same period – meaning that there was little net change to their total issued
ordinary shares.
Clearly FS participants were quite content with the ordinary share component of their Common Equity
Tier 1 position over the period.
However, it is understood that banks are now starting to use their DRIPs to issue shares. Some of
the reasons for this are discussed in section 2.4 below.
Theme #4: increased bank debt funding
The financial accounts of the big 4 banks and Macquarie for the last 2 financial reporting periods
indicate that:

total debt funding increased 9% to around $2.6 trillion;

debt funding comprises deposits, short term and long term wholesale debt, hybrids and interbank funding;

deposits are the overwhelming source of debt funding for the big 4 banks, comprising
approximately 75% of their total debt funding. In contrast, approximately 40% of Macquarie’s
debt funding is sourced from customer deposits while its level of wholesale debt funding is
higher;

total deposits increased by around 10% during the 2014 financial year for each of the big 4
banks;

wholesale debt markets are the next biggest source of debt funding, comprising
approximately 20% of total debt funding;

total wholesale debt increased by around 10%;

hybrid funding comprises only around 2% of total debt funding; and

total hybrid funding increased by around 11% over the period.
The following chart provides a snapshot of the debt funding mix of the big 4 banks and Macquarie as
at the end of their respective 2014 financial reporting periods.
Sources of debt funding - 2014
Deposits (73%)
Debt issues (bonds, notes
etc.) (20%)
Interbank payables (5%)
Loan capital (hybrids)
(2%)
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Theme #5: very few returns of invested capital
Other than regular dividends and retiring older hybrids (see themes #1 and #2), FS participants
returned very little capital (in the narrower sense of invested capital) to investors.
The notable exception was Macquarie Group’s in specie distribution of Sydney Airport (SYD)
securities, which is dealt with in section 4.2 below.
Theme #6: much lower levels of activity outside the larger banks
For FS participants outside the larger banks, paying dividends was generally the most meaningful CM
activity during the period.
Nevertheless, a number of these players were also actively issuing hybrids, for example:

Bendigo and Adelaide Bank issued CPS and subordinated notes;

Bank of Queensland issued CPS;

Suncorp issued two tranches of CPS and subordinated notes;

AMP issued subordinated notes; and

Challenger issued capital notes and issued ordinary shares under a placement.
2.4 The likely future direction of CM activity
A number of current developments are likely to put upward pressure on the regulatory capital
requirements of banks – or at the very least cause them to revisit their regulatory capital mix.
The three recommendations in the Financial System Inquiry Final Report (Murray Report) that are of
particular interest to banks are discussed below. The discussion is kept at a relatively high level in
recognition of the fact that the recommendations will be dealt with in more detail in other papers
prepared for this conference.
The CM activities of non-bank FS participants aren’t directly impacted by the Murray Report
recommendations – for example the Murray Report concludes at page 36 that it “has not seen a
compelling case for further changing stability settings in insurance at this stage”.
2.4.1 Recommendation 1: ADI capital levels
Recommendation 1 is to set capital standards such that ADI capital ratios are “unquestionably strong”.
The Murray Report concludes at page 34 that:
“although Australian ADIs are generally well capitalised, further strengthening would assist in
ensuring that capital levels are, and are seen to be, unquestionably strong”.
The recommended setting is the “top quartile of internationally active banks”: see page 57.
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3
The following chart puts the Common Equity Tier 1 capital ratios of major Australian banks as at
December 2013 in an international context. The plausible range is between 10.0% and 11.6% (ie, the
th
orange section) while the global 75 percentile is 12.2%. This highlights the work that will need be
done in order for them to – as a group – achieve the top quartile setting.
This recommendation expressly applies to CET1 regulatory capital (principally ordinary shares and
retained earnings) – although some discretion was for APRA to permit any required increases to take
the form of other loss absorbing capital (ie, Additional Tier 1 hybrid securities). Industry does not hold
great hopes of that happening.
As yet unspecified transitional periods will be permitted: see page 59.
This recommendation raises a number of issues including:

as the Murray Report notes in recommendation 4, there is currently a “comparing apples with
oranges” issue because of the divergent ways in which different jurisdictions measure
regulatory capital ratios; and

the practical challenges associated with aiming at what is a constantly moving regulatory
capital target.
Importantly, this recommendation applies to all ADIs – that is, it is not confined to what have been
categorised as Australia’s domestic systemically important banks (DSIBs) ie, the big four banks.
It was widely reported in the financial press that the prospect of non-DSIBs having to raise additional
regulatory capital had a negative effect on their share price in the period following the release of the
Murray Report.
2.4.2 Recommendation 2: narrow bank mortgage risk weight differences
The amount of a regulated entity’s regulatory capital is based on the quantum of its risk weighted
assets.
The big 4 banks and Macquarie are currently able to take a more lenient approach to risk weighting
their assets, called the internal ratings-based approach. This means that – even if they held identical
3
Murray Report page 49
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mortgage assets – these banks would be able to hold less regulatory capital than a bank that uses the
standard approach.
Recommendation 2 is to:
“… raise the average mortgage risk weight to narrow the difference between average
mortgage risk weights for ADIs using risk-weight models and those using standardised risk
weights.”
This recommendation would require the big four banks and Macquarie to apply a higher risk weighting
percentage to their mortgage assets – resulting in them having to hold a greater amount of regulatory
capital in respect of those assets than they currently do.
The Basel Committee on Banking Supervision (BCBS) has picked up on this issue, releasing a
number of consultation documents on 22 December 2014.
4
2.4.3 Recommendation 3: ADI loss absorbing and recapitalisation capacity (TLAC)
Recommendation 3 is to:
“… implement a framework for minimum loss absorbing and recapitalisation capacity in line
with emerging international practice, sufficient to facilitate the orderly “resolution” of Australian
ADIs and minimise taxpayer support”.
The precise ambit of this recommendation is currently unclear and will be shaped at least in part by
international developments in this area.
However, what is clear is that the concept of total loss-absorbing capacity (TLAC) will become part of
the Australian FS regulatory environment for banks.
TLAC is a concept developed at the international level by the Financial Stability Board (FSB). The
FSB released for public consultation on 10 November 2014 a set of principles and a detailed term
sheet on the adequacy of loss-absorbing and recapitalisation capacity of global systemically important
5
banks (GSIBs) .
The motivation appears to be that GSIB – issued unsecured debt currently benefits from an implicit
public subsidy, which gives them a funding advantage over other non-GSIB banks which don’t benefit
from the same implicit support.
However, if GSIBs are required to hold a greater total amount of capital with loss absorption features,
then the value of the implicit guarantee will be reduced or eliminated and so their funding advantage
will be reduced.
What this appears to mean is that, going forward, a portion of a GSIB’s unsecured debt must be loss
absorbing if a non-viability trigger event occurs.
4
http://www.bis.org/bcbs/publ/d307.htm, http://www.bis.org/bcbs/publ/d308.htm
http://www.financialstabilityboard.org/2014/11/fsb-consults-on-proposal-for-a-common-international-standard-on-total-lossabsorbing-capacity-tlac-for-global-systemic-banks/
5
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This effectively introduces a new third tier of regulatory capital – in addition to Tier 1 and Tier 2
regulatory capital - that sits between Tier 2 regulatory capital and senior unsecured debt in the
creditor hierarchy.
The FSB timetable calls for the TLAC proposals to be finalised by the time of the G20 Leaders’
Summit in November 2015.
The Murray Report refers at page 69 to indications that many countries will also adopt TLAC
requirements for DSIBs and concludes that Australia must follow suit.
But who will be subject to TLAC requirements and how much TLAC will be required?
The Murray Report refers to a range of 16-20% of risk-weighted assets for GSIBs (or around twice the
current regulatory capital minimums) and concludes at page 73 that a similar quantum may be
appropriate for “internationally active Australian ADIs”. For other domestic banks, the TLAC
requirement is likely to be a lower – albeit unspecified – amount.
It will be interesting to see the length of the transitional period for the new TLAC requirements. The
expectation is a 5 to 10 year period. But, whatever that period be, banks will likely soon have to retire
existing unsecured debt and issue new “Tier 3” debt.
2.4.4 Conclusion
The Murray Report recommendations and international regulatory developments discussed above are
likely to have an impact on the capital mix of Australian banks in particular.
Press speculation is that banks will be required to issue significant amounts of ordinary shares.
Banks typically have the capacity to issue a significant number of ordinary shares under their widely
utilised DRIPs – and this may well address much of their needs.
However, it may well be the case that we will see greater use of CM activities such as rights issues
and share placements. A number of current issues with rights issues are dealt with comprehensively
6
in the Richard Hendriks & Cameron Blackwood paper entitled “Capital Management” and so are not
repeated in this paper.
We can also expect that a large amount of hybrids will continue to be issued in the short to medium
term in order to maintain let alone increase Tier 1 and Tier 2 regulatory capital levels. Tax issued
associated with hybrids are dealt with in section 3.
It may also be the case that, when the parameters of the new regulatory regime become clearer, ADIs
will look to rebalance the particular components of their regulatory capital to produce the most
efficient outcomes. For example, some of the big 4 banks may well be confident that they have
excess ordinary shares on issue and so may look to return some of that capital to ordinary
shareholders and replace it with cheaper forms of regulatory capital instead. Share buy-backs may
well see a resurgence. Current tax issues associated with buy-backs are dealt with comprehensively
in the Richard Hendriks & Cameron Blackwood paper and so are not repeated in this paper.
6
The Tax Institute NSW 7th Annual Tax Forum 22 May 2014
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3 Hybrids
3.1 Overview
A hybrid security is a generic term used to describe a security that combines debt and equity features.
In the Australian FS market, hybrids are issued as regulatory capital and currently encompass three
types of securities:
•
convertible/converting preference shares (CPS);
•
•
capital notes; and
convertible/converting debt securities.
3.2 Regulatory capital requirements
Part 1 of the Ho-Hudson/Frost paper dealt comprehensively with the regulatory capital requirements
applicable to banks and insurers. In particular, that article dealt with the Basel III reforms and set out
the key features of Additional Tier 1 securities and Tier 2 securities.
All those matters still apply and so are not repeated in this paper.
3.3 Snapshot of the Australian FS hybrids market
The six categories of hybrid instruments
The hybrids issued by FS participants since the start of 2013 fall into six categories.
1
Type
Regulatory
capital
Examples
CPS issued by the Australian head office
to Australian residents
Additional Tier 1
NAB CPS and CPS2, Suncorp
CPS3 and Bendigo and Adelaide
Bank CPS2
2
Capital notes (legal form debt securities
that are tax equity) issued by the
Additional Tier 1
Australian head office to Australian
residents
Macquarie Group Capital Notes
and Macquarie Bank Capital
Notes, ANZ Capital Notes and
Capital Notes 2, Westpac Capital
Notes 2 and Challenger Capital
Notes
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Type
Regulatory
capital
Examples
Capital notes issued by a foreign branch
to Australian residents yet which have
Additional Tier 1
CBA PERLS VII, ANZ Capital
Notes
Additional Tier 1
Macquarie ECS
Tier 2
Suncorp Subordinated Notes,
Westpac Subordinated Notes II,
frankable distributions
4
Capital notes issued by a foreign branch
to foreign residents which are intended
to have unfrankable distributions by
application of s.215-10
5
Legal form debt securities that are tax
debt issued by the Australian head office
Westpac (unlisted) Subordinated
Notes, AMP Subordinated Notes
2, Bendigo and Adelaide Bank
(unlisted) Subordinated Notes
6
Legal form debt securities that are tax
debt issued by a foreign subsidiary
Tier 2
There are a number of wholesale
issues of this type
The three markets
The current market can be dissected into three distinct investor markets:

domestic retail;

domestic wholesale; and

foreign.
Of these, publicly available information centres on the domestic retail market.
As the following chart provided by ANZ demonstrates, domestic retail market issues are now all about
Additional Tier 1 securities.
2012
S&P 50%
equity
credit,
$1550m,
12%
2013
Leveraged
Note,
$305m, 3%
Senior bond,
$423m, 3%
S&P/Moody's
50/50%
equity
credit,
$1047m, 8%
Tier 1
capital,
$4696m,
36%
Tier 2
capital,
$2020m,
23%
S&P 100%
equity
credit,
$900m, 7%
Leveraged
Note,
$155m, 1%
2014
Tier 2
capital,
$4358m,
33%
© Tim Kyle, Greenwoods & Herbert Smith Freehills – February 2015
Tier 1
capital,
$6330m,
73%
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Issuances into the domestic wholesale market and the foreign market are largely confined to Tier 2
securities, as the ATO interpretation of s.215-10 has for a number of years compromised the issue of
unfranked Additional Tier 1 securities (see section 3.6 below). Tier 2 issuances into these markets
have increased in recent years as issuers chase lower margins (see below).
Margins
The margin that the issuer pays above BBSW is a reflection of a number of things, including the credit
rating of the issuer, the ranking of the particular security and the level of investor demand.
A number of observations can be made about the margins on hybrids issued during the period:

the margins have been relatively steady;

the margins on Tier 2 subordinated notes issued into the domestic retail market have been in
the range of 2.3 to 2.8%;

margins on Tier 2 subordinated notes issued into the domestic wholesale and foreign markets
have been lower (now around 1.8%)

the margins on Additional Tier 1 CPS and equity notes have generally been between 3.2 and
3.4%, with the outlier being CBA’s PERLS VII at 2.8% (although they are currently trading at
less than face value, implying a comparable yield); and

there is an upward trend in the margins for Additional Tier 1 instruments issued into the
domestic market after PERLS VII – consistent with press speculation about supply having run
ahead of domestic demand for hybrids. This puts further pressure on the ATO to update their
view on s.215-10 so that banks can start issuing Additional Tier 1 instruments into the foreign
market – see further section 3.6 below.
3.4 Tax issues associated with hybrids
Part 2 of the Ho-Hudson/Frost paper dealt with the following Australian income tax issues for both
issuers and investors.
Issuance type
Tax issues addressed
Domestic issuances of Additional
Tier 1 capital (ie, CPS and capital

tax equity characterisation

frankability of distributions
notes)

Division 230 consequences

the commercial debt forgiveness (CDF) provisions

treatment of gains/losses to the issuer on cessation

the s.204-30 dividend streaming rule

the s.177EA franking anti-avoidance provision

s.215-10

the application of s.177EA in relation to
frankable/deductible instruments
That is, types 1 and 2 in the table
in section 3.3
Offshore issuances of Tier 1 capital
That is, types 3 and 4 in the table
in section 3.3
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Issuance type
Tax issues addressed
Domestic and offshore issuances
of Tier 2 capital
That is, types 5 and 6 in the table

the conduit foreign income rules

tax debt characterisation

the “traditional security” definition

the treatment of gains/losses to the issuer on cessation
in section 3.3
These issues were dealt with comprehensively in the Ho-Hudson/Frost paper and so are not repeated
in this paper. Rather, the focus of the balance of this section 3 is on developments that post-date that
paper.
3.5 Board of Taxation debt/equity discussion paper
The Board of Taxation is charged with conducting a review of the debt and equity tax rules.
The Board of Taxation’s discussion paper dated March 2014 deals with a number of tax issues
associated with hybrids (Board of Taxation debt/equity discussion paper).
Many of the issues are well known and need not be dealt with in this paper.
However, interestingly, the Board of Taxation debt/equity discussion paper does ask for input on:
“whether … there should be a legislative provision for entities regulated by APRA that aligns
tax characterisation with prudential characterisation, with a regulation-making power available
to exclude particular items”
7
The context for this question is the observation in paragraph 9.17 that a number of regulations have
been made under s.974-135 ensuring that issuers of Tier 2 regulatory capital have effectively noncontingent obligation (ENCO) in relation to amounts payable under those instruments, despite
regulatory requirements for their terms that may well otherwise result in ENCO not being present in
respect of those amounts.
In particular:
•
regulation 974-135D deals with Basel II term cumulative subordinated notes with
•
insolvency or capital adequacy conditions;
regulation 974-135E deals with Basel II perpetual cumulative subordinated notes with
•
profitability, insolvency or negative earnings conditions; and
regulation 974-135F deals with Basel III term cumulative subordinated notes with nonviability conditions.
7
See question 9.1b on page 4138
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The observation made at paragraph 9.21 is that this approach is reactive and piecemeal – and that it
may be preferable to take the more proactive and comprehensive approach of making a regulation
that all Tier 2 regulatory capital instruments are classified as debt for Division 974 purposes.
The ABA submission to the Board of Taxation supported that suggestion – while also suggesting that
debt treatment should extend to Additional Tier 1 instruments, as it does in a number of other
jurisdictions.
It will be interesting to see where the Board of Taxation lands on these points.
3.6 Section 215-10
There has been an important development in relation to s.215-10.
Part 2 of the Ho-Hudson/Frost paper addressed in detail the background to s.215-10 and the
difficulties with the ATO interpretation in TD 2012/19.
By way of recap:
•
s.215-10 renders unfrankable non-share distributions made by Australian ADIs on nonshare equity interests issued “at or through a permanent establishment in a listed country”
provided the funds from the issue are raised and applied solely for permitted purposes;
•
s.215-10 is a concession, removing the competitive disadvantage that banks would
suffer if those non-share distributions (paid in all likelihood to non-residents) were
franked;
•
the provision seemed to work well between 2001 and 2008, with the ATO issuing a
number of favourable private rulings;
•
in about 2008, the ATO adopted a more restrictive interpretation of the manner in which
an instrument could be issued in order to satisfy s.215-10 – in effect the ATO read in an
additional test: the issue must be a transaction of the business of the permanent
•
establishment which must be a banking business; and
that ATO interpretation was reflected in an edited (unfavourable) private ruling on the
ATO register of private rulings and subsequently in TD 2012/19.
Industry vigorously opposed the ATO interpretation on technical grounds and on the basis that it
effectively rendered s.215-10 inoperable, as reflected in paragraphs 6.61 of the Board of Taxation
debt/equity discussion paper.
That opposition finally proved successful, with TD 2012/19 being withdrawn on 8 October 2014.
Industry expects the ATO to publish its updated view on the application of s.215-10. However, the
timing is uncertain and bank issuers don’t have the benefit of a ruling in the interim.
I understand that issuers are looking forward to an updated ruling, as this would allow them to once
again start issuing Tier 1 regulatory capital to offshore residents.
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3.7 BEPS
The OECD’s base erosion and profit shifting (BEPS) action plan will impact “frankable deductible”
instruments if it is the case that:

they are relevant hybrid arrangements; and

the scope requirement is satisfied.
Relevant hybrid arrangement?
Legal form notes that are “frankable deductible” can be seen as benefiting from differences in their tax
characterisation under two tax systems. For example, the notes may be seen as debt in New Zealand
yet equity in Australia for the purposes of the respective tax regimes, with the consequence that
periodic returns paid to holders are deductible against New Zealand income yet are also frankable
distributions.
The OECD announced 15 Actions relating to base erosion and profit shifting in July 2013. Action 2
was directed towards developing measures to neutralise the effects of hybrid mismatch arrangements
arising in respect of instruments and entities.
Hybrid mismatch arrangements had previously been the subject of a March 2012 OECD paper. They
were then the subject of two OECD papers in March 2014 (one on domestic law issues and one on
treaty issues) and another OECD paper in September 2014.
As Graeme Cooper noted in his University of Sydney Law School presentation “Coordinating
Inconsistent Choices – the Problem of Hybrids” the approach taken by the OECD in these papers is
curious.
The OECD could have taken a principled approach directed towards reversing all mismatches that
lead to hybrid outcomes. Instead, what it has done in relation to hybrid instruments is produce a
shopping list of ostensibly unrelated scenarios and proposed domestic law “fixes” for each of them –
proposals in search of a principle as Graeme puts it.
More specifically, the OECD has identified six particular arrangements that result in “deduction/no
inclusion”, “double deduction” and indirect “deduction/no inclusion” mismatches and recommended a
primary response and defensive rule to counter each of them.
But does a frankable deductible instrument fit within any of these six identified arrangements?
The most likely applicable category is as a deduction/no inclusion outcome (D/NI outcome). That will
be the case according to the key terms section on page 71 of the September 2014 paper if the
payment is deductible in the payer jurisdiction but is not included in ordinary income by any person in
the payee jurisdiction.
However, distributions on frankable deductible instruments – while deductible in the payer jurisdiction
(ie, New Zealand) – are not excluded from being assessable in Australia. Rather, they are included in
assessable income and a credit is provided for underlying tax paid by the issuer.
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Nevertheless, balancing this, franking is now a rare feature in world terms and so it is not surprising
that the September 2014 OECD paper did not address franking specifically.
Moreover, the earlier March 2014 OECD paper expressly stated (at page 27) that the term “included
in ordinary income” in this context means that the income:
“… is subject to tax at the taxpayer’s full marginal rate and does not benefit from any
exemption, exclusion, credit or other tax relief applicable to particular categories of payments
(such as credits for underlying tax paid by the issuer).”
Finally, in late 2014, one senior OECD officer familiar with this issue emphatically expressed the view
that Action 2 will apply to frankable deductible instruments.
In light of the above, it would be conservative to assume that frankable deductible instruments will be
characterised as producing D/NI outcomes 2.
The scope requirement
The March 2014 OECD paper envisaged its scope to be arrangements between related parties and
arrangements designed to produce a mismatch – albeit that generally the scope would not extend to
widely held instruments.
This suggested that retail hybrid offers may be outside the scope of Action 2.
However, the September 2014 OECD paper clearly includes (all) “structured arrangements” within its
scope – regardless of whether they are widely held. This term is defined on page 67 of that paper as:
“… any arrangement where the hybrid mismatch is priced into the terms of the arrangements
or the facts and circumstances (including the terms) of the arrangement indicate that it has
been designed to produce a hybrid mismatch.”
That definition, reinforced by the examples provided, make it difficult to escape a conclusion that
frankable deductible instruments may qualify as “structured arrangements” and so be within scope of
Action 2, even if widely held.
It will be interesting to see whether a concession for widely issued regulatory capital of banks and
insurers emerges from the OECD’s further work in this area.
Recommended responses
The OECD’s recommended response in the event of a D/NI outcome is:

for the issuer to be denied a deduction for the distribution; and

only if that is not done, for the distribution to be included in the investor’s ordinary income.
Therefore, distributions on frankable deductible instruments will only potentially be denied franking
credits if New Zealand fails to deny the issuer the New Zealand deduction.
Of course, questions of grandfathering remain.
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Concluding observations
This topic will be impacted by further OECD work. Australian issuers (and potential issuers) of
frankable deductible instruments will no doubt be monitoring developments very closely.
3.8 A regulatory capital “haircut”?
Issuers expect to receive dollar for dollar recognition for regulatory capital issued.
However, APRA has been - and continues to be - very interested in whether the loss absorption
features of Tier 2 securities can generate a tax liability for the issuer, if and when those features are
activated, eg, at the point of non-viability.
If a tax liability were generated, APRA would impose at the time of issue a “haircut” and discount the
amount of regulatory capital recognised by the amount of potential tax.
This “haircut” would require issuers to issue a greater amount of hybrids in order to secure a given
level of regulatory capital. That is, an issuer subject to a 30% tax rate would have issue almost $143
of hybrid instruments to get recognition for $100 of regulatory capital – clearly a sub-optimal outcome.
APRA now has a relatively long-standing practice of accepting that no haircut is required where the
loss absorption method is industry standard.
To support that practice, APRA requires that the issuer procure an opinion from an external adviser,
addressing the matters discussed below.
These opinions are required in respect of each issue of Additional Tier 1 and Tier 2 securities.
For a while APRA was satisfied if it was provided with the advice. More recently, APRA requires that
the advice state that APRA can rely on the advice to perform its statutory task of assessing the
instruments for inclusion in the issuer’s regulatory capital. (APRA also insists on being able to rely on
corresponding advice prepared by advisers in other disciplines such as accounting.)
The more interesting issues in this area arise in respect of Tier 2 securities.
3.8.1 Tier 2 securities
Loss absorption features
Relevantly, in order to qualify as bank regulatory capital, APS 111 requires that instruments have one
or more of the following loss absorption features in the event of a non-viability trigger event:
•
the instruments convert into ordinary shares in the issuer or its parent; or
•
they are written off.
A non-viability trigger event happens when APRA notifies the issuer that it would be non-viable
without loss absorption or a public sector injection of capital.
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Industry practice is for conversion into ordinary shares to be the default loss absorption feature. Only
if conversion does not eventuate will write off ever occur.
Restated, the loss absorption features of Tier 2 securities may never be activated. And, if they are,
industry practice is that conversion is the primary loss absorption mechanism - so that writing off
would only ever occur in unforeseen circumstances.
Nevertheless, a number of wholesale subordinated note programmes do allow for writing off to be the
primary loss absorption mechanism for particular notes, if specified at the time of issue.
The conversion and writing off mechanisms are discussed below.
Conversion
Typically, conversion of Tier 2 securities is effected in a two-step cashless transaction:
•
first the principal amount is repaid to the holder; and
•
secondly the holder subscribes for a particular number of ordinary shares.
Conversion of Tier 2 securities may well not generate an economic gain to the issuer. This is
because, under most conversion ratios, a Tier 2 security with a $100 principal amount will convert into
ordinary shares with a market value of $101.
Nevertheless, APRA requires that the number of ordinary shares that can be issued upon conversion
be capped by a maximum exchange number formula. This prevents excessive dilution of existing
ordinary shareholders in the event that the market value of the ordinary shares has fallen
considerably.
Even if an economic gain did arise to the issuer upon conversion of Tier 2 securities because the
maximum exchange number formula has been engaged, it is considered that no tax liability should
arise for the issuer. The relevant considerations for the issuer are summarised below.
Relevant
provisions
Observation
CGT provisions
Not applicable as Tier 2 securities are liabilities of the issuer, rather than assets
Division 230
Conversion prima facie requires a balancing adjustment to be made. However,
the exception in s.230-440(3)(c) for conversion of traditional securities should
apply so that no gain arises to the issuer under Division 230
(It is expected that Tier 2 securities should be traditional securities despite their
loss absorption features – although ATO confirmation of this point would be
welcome)
Ordinary income
Conversion following a non-viability trigger event is clearly distinguishable from
the gain arising to an issuer upon an opportunistic purchase of its Tier 2
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provisions
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Observation
securities at a discount: ATO ID 2011/100
Rather, the economic gain is not made with a profit making purpose and should
not be seen as an ordinary incident of the issuer’s business. Accordingly, it
should not be ordinary income of the issuer
CDF provisions
The CDF provisions should not apply on the basis that the conversion
mechanics do not constitute a forgiveness due to the very specific ordering of
events contemplated in the debt/equity swap provision in s.245-37
APRA has a longstanding practice of accepting that no “haircut” is required in respect of the
conversion of Tier 2 securities.
Writing off
Typically, writing off of Tier 2 securities is effected by the holders’ rights being immediately and
irrevocably terminated for no consideration.
If an issuer writes off Tier 2 securities, it is entirely relieved of its obligations and so makes an
economic gain. The relevant considerations for the issuer are summarised below.
Relevant
Observation
provisions
CGT provisions
Not applicable as Tier 2 securities are liabilities of the issuer, rather than assets
Division 230
The issuer should make a balancing adjustment gain, subject to reduction
under s.230-470 by the debt’s net forgiven amount under the CDF provisions
(see further below)
Ordinary income
The economic gain is not made with a profit making purpose and should not be
seen as an ordinary incident of the issuer’s business. Accordingly, it should not
be ordinary income of the issuer
CDF provisions
The CDF provisions should apply (see further below)
There is a degree of tension between Division 230 and the CDF provisions because of a shortcoming
in the anti-overlap provisions.
Division 230 yields to the CDF provisions: s.230-470. However, the CDF provisions potentially yield
to Division 230, as the gross forgiven amount of a debt is reduced by any amount that is included in
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assessable income as a result of the forgiveness of the debt under any provision outside the CDF
provisions (eg, Division 230).
So, Division 230 will not tax the gain if the CDF provisions apply and the CDF provisions will not apply
if Division 230 taxes the gain.
How can this “chicken and egg” conundrum be resolved?
The answer is to be found in principles of statutory construction. In that regard, the High Court
decision in Project Blue Sky Inc v Australian Broadcasting Authority (1998) 194 CLR 355 is of
particular assistance. The High Court held that, where there are conflicting statutory provisions, a
court must establish a hierarchy of provisions (ie, identify a “leading” provision and a “subordinate”
provision) to best give effect to the purpose and language of the provisions while maintaining the unity
of the statutory regime.
In this regard:

Division 230 post-dates the CDF provisions (albeit that the CDF rules were transposed into
the 1997 Act after Division 230 was introduced);

the EM to the bill that introduced Division 230 indicates relatively clearly that the CDF
provisions should prevail; and

if Division 230 prevailed, then s.230-470 would be made entirely redundant.
In light of the above matters, it is widely regarded that Division 230 should yield to the CDF
8
provisions .
Importantly, where the CDF provisions apply, they do not of themselves generate a tax liability for the
issuer. Rather, certain tax attributes of the issuer are reduced according to the waterfall in
Subdivision 245-E: carry forward tax losses, carry forward net capital losses, amortisable amounts
including the cost of deprecating assets and borrowing costs and, finally, the cost base of
depreciating assets. Any excess does not impact tax attributes or have any other consequences for
the issuer.
It should also be borne in mind that, if a non-viability trigger occurs, the issuer is likely to be in a
parlous state and so unlikely to be in a tax paying position any time soon – even if the CDF provisions
erode the tax attributes listed above. Balancing this, the reduction of tax attributes puts the issuer
closer to being in a tax paying position – albeit that position might be years away.
APRA has a longstanding practice of accepting that no haircut is required in respect of the writing off
of Tier 2 securities, at least where conversion is the primary loss absorption mechanism.
It is understood that banks are keen to issue Tier 2 securities with write off as the (only) loss
absorption mechanism because ordinary shareholders are not diluted and indeed it is preferable for
investors with debt only mandates. Therefore, banks remain keen for the regulatory treatment to be
resolved favourably.
8
The position would be more nuanced if the economic gain was ordinary income.
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3.8.2 Tier 1 instruments
Ordinary shares (which are Common Equity Tier 1 regulatory capital) already absorb losses and
contain no special loss absorption terms that require analysis.
Other regulatory capital instruments that are legal form shares (such as CPS) typically satisfy the loss
absorption requirements for regulatory capital by being convertible into ordinary shares – and typically
their terms do not provide for them to be written off (writing off is a difficult concept for legal form
shares).
The tax issues arising in respect of Additional Tier 1 regulatory capital instruments that are legal form
debt, such as capital notes, are a (less interesting) subset of those discussed above in respect of Tier
2 securities. Broadly, the differences are as follows:

Division 230 does not apply to issuers in respect of equity interests;

the CDF provisions do not apply to capital notes for reasons including that distributions are
not deductible; and

any economic gain to the issuer is even more likely to be capital in character.
3.9 Blank’s case and non-share equity
A storm in a teacup seems to have been resolved sensibly.
Legal form notes can only be either debt or equity for Division 974 purposes if the relevant scheme is
a “financing arrangement”: s.974-20(1)(a) and s.974-75(2).
The term “financing arrangement” is defined in s.974-130. Relevantly, a scheme will generally only
satisfy that definition if it was entered into or undertaken to raise “finance” (an undefined term) for the
entity or a connected entity.
When an entity issues regulatory capital, be it by capital notes or subordinated notes, the
conventional view is that the issuer is raising finance in the relevant sense. That is consistent with
long standing ATO practice evidenced in many class rulings.
However, certain comments by Edmonds J in Blank v FCT [2014] FCA 87 (Blank) could be seen as
casting some doubt on that proposition.
Relevantly, in Blank, an employee of the corporate group subscribed for shares in the group holding
company in connection with the employee rewards programme.
Edmonds J held that, having regard to all of the relevant facts and circumstances, when it issued the
shares, the holding company did not “raise finance”.
This was relevant to the Division 974 characterisation of (different) non-share interests issued by a
connected entity of the holding company. Consequently, paragraph (a) of the s.974-130(1) definition
of the term “financing arrangement” was not satisfied in relation to those non-share interests.
Edmonds J drew a distinction between raising finance and raising capital – with the former being
narrower than the latter, in his view. See in this regard paragraph 69 onwards.
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His Honour made some further obiter comments which could conceivably be seen as throwing some
doubt on whether the issue of non-share regulatory capital involves raising finance. The relevant
comments are underlined in the text of paragraph 71 which is extracted below:
Equally, the amount of capital raised by the issue of shares will not, of itself, be determinative
of whether the arrangement is entered into or undertaken to raise finance for the company
issuing the shares. But para (a) of the definition of “financing arrangement” requires the
scheme to be entered into or undertaken “to raise finance for the entity”, not just capital. The
two are not coterminous, and a conclusion that a scheme is entered into or undertaken to
raise capital for prudential, management or other good governance reasons will not be
entered into or undertaken to raise finance which contemplates, sooner or later, expenditure
of the amount raised. Unless that dichotomy is observed, each and every raising of capital,
irrespective of the objective purpose of the raising, will be a raising of finance. In my view,
such a conclusion is not consistent with the legislative intention to be discerned from the text
of s 974-130(1), viewed in the context of Div 974 of the 1997 Act as a whole. [emphasis
added]
It may be that his Honour had in mind the issue of instruments that comply with APRA prudential
requirements when he refers to capital raised for “prudential reasons”.
If so, his comments could be seen as suggesting that the issue of regulatory capital necessarily
involves something other than the raising of finance – in which case regulatory capital that is legal
form debt would be incapable of being either debt or equity interests for Division 974 purposes.
This outcome may not adversely impact Tier 2 capital, as losses associated with interest payments
may be deductible to the issuer under Division 230 in any case. However, it would jeopardize the
frankability of distributions on capital notes. (This issue is confined to interests that are not shares, as
shares can be equity interests without being a financing arrangement: s.974-75(2).)
We immediately raised this potential issue with the ATO and set out a number of bases upon which
His Honour’s comments could be distinguished. In particular:
•
As his Honour notes at paragraphs 70 and 72, regard to all of the relevant facts and
circumstances is essential to the task of determining whether a particular capital raising
involves raising finance.
•
APRA regulated entities invariably raise regulatory capital not just to satisfy prudential
regulations, but also to expend the raised funds - typically in the very short term. These
funds typically become circulating capital (ie, they are applied for general corporate and
business purposes) of the issuer and/or subsidiaries of the issuer. That is, the issuer
•
doesn’t just put the money raised in a tin.
His Honour clearly accepts that the hallmark of raising finance is that the funds raised are
expended, sooner or later.
•
That is, even without having regard to any other facts and circumstances, the issue of
instruments that comply with APRA prudential requirements should invariably involve
raising finance as His Honour conceives it.
The issue was then ventilated in the Board of Taxation debt/equity discussion paper – but fortunately
the ATO has taken a sensible interpretation of His Honour’s comments and has continued to issue
class rulings on the basis that raising regulatory capital involves the raising of finance. Indeed the
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ATO now includes specific comments in private rulings differentiating regulatory capital from the
arrangements considered in Blank’s and specifically concluding – in light of the relevant facts and
circumstances – that raising regulatory capital involves the raising of finance.
3.10 Financing regulatory capital of a subsidiary
Subsidiaries of some corporate groups require regulatory capital.
It is often the case that the head company of the corporate group publicly issues instruments (which
are not strictly speaking regulatory capital) and then applies the subscription amounts (net of costs) in
subscribing for regulatory capital in the relevant subsidiary.
It may be the case that the legal form of the instruments vary – for example the head entity may issue
CPS while the head entity subscribes for notes in the APRA regulated subsidiary. However, what is
important is that the instruments issued by the head entity and the instruments issued by the
subsidiary typically contain the same terms – that is, that they are “back to backed”.
However, there are instances of group subsidiaries issuing regulatory capital directly to the public.
Examples of this include Macquarie Bank issuing Macquarie Bank Capital Notes. Also, a number of
foreign subsidiaries have issued Tier 2 capital.
These issues directly by group subsidiaries involve conversion and write off mechanics that are not
industry standard, and so involve some additional tax nuances.
3.11Available frankable profits
Broadly, distributions paid on non-share equity (such as capital notes) are only frankable if the issuer
has sufficient “available frankable profits”, as defined.
Up until now, generally little attention has been given to the meaning of the term “available frankable
profits”. However, a few intricacies are worth ventilating.
3.11.1 The relevant provisions
Distributions on Additional Tier 1 securities that are legal form debt, such as capital notes, are “nonshare distributions” as defined in s.974-115.
Unless debited to a share capital account or a non-share capital account they are “non-share
dividends” as defined in s.974-120.
A non-share dividend is a “frankable distribution” to the extent that it is not unfrankable under s.20245: s.202-40.
Paragraph 202-45(f) makes unfrankable “an amount that is taken to be an unfrankable distribution
under section 215-10 or 215-15”.
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Broadly, s.215-15 renders a non-share dividend unfrankable to the extent that there are insufficient
“available frankable profits” to support the non-share dividend.
The process for quantifying a corporate tax entity’s available frankable profits is set out in s.215-20
and can be expressed this way:

step 1: start with the entity’s “maximum frankable amount“ (see below);

step 2: subtract any “committed shared dividends” (see below); and

step 3: subtract any “undebited non-share dividends” (see below).
Importantly, s.215-25 permits a corporate tax entity to anticipate available frankable profits in certain
circumstances.
The purpose of s.215-15
The purpose behind s.215-15 was put succinctly in the Explanatory Memorandum to the bill that
introduced it:
“10.46 Section 215-15 makes distributions paid on non-share equity interests debited to nonprofit sources (e.g. share capital or asset revaluation reserves) unfrankable. A company
cannot frank non-share dividends unless it has available frankable profits. The purpose of this
treatment is to ensure that non-share dividends are treated in the same way as dividends paid
on shares debited to non-profit sources, so that these distributions cannot be used to stream
franking credits.”
Restated, the intention is to align the pools of profits that can support the franking of dividends and
non-share dividends.
Maximum frankable amount
Broadly, an entity’s “maximum frankable amount” is defined to mean the maximum amount of
dividends that the entity could pay at that time having regard to its available profits at that time.
The term “available profits” is undefined.
The ATO view reflected in ATO ID 2010/21 is - quite sensibly - that it is the profits from which a
company can pay dividends.
The ATO view in PBR 1012314581514 is that the concept is confined to realised profits - although
this view may proceed on an overly narrow understanding of the operation of s.254T.
Committed share dividends
Broadly, “committed share dividends” means any dividends on shares paid at the same time or
committed/resolved to be paid at a later time.
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Undebited non-share dividends
Broadly, “undebited non-share dividends” means the sum of the franked parts of any non-share
dividends that:

were not debited to the entity’s available profits; and

were paid within the 2 income years preceding the particular non-share dividend.
It is more difficult to understand what was sought to be achieved under step 3. Hybrids that are nonshare equity are almost invariably liabilities for accounting purposes. As they are in the debt section
of the balance sheet rather than the equity section, distributions on these hybrids simply aren’t
debited to available profits. Rather, they are expensed for accounting purposes and so already
reflected in the computation of available profits.
So, on a strict view of the definition, those distributions might be double counted to the detriment of
the issuer - firstly they reduce the available profits number itself and secondly are they required to be
subtracted as undebited non-share dividends.
If so, that would result in a lack of alignment between the pools that can support the franking of
dividends and non-share dividends.
However, the ATO took a sensible approach in the edited PBR with Authorisation Number
1012314581514.
There, the ATO applied a purposive interpretation in order to conclude that non-share dividends that
were expensed for accounting purposes were not undebited non-share dividends.
3.11.2 Corporate law changes
Corporate law changes may cause s.215-15 to no longer achieve its purpose.
Before June 2010, s.254T of the Corporations Act 2001 only permitted a dividend to be paid out of
profits of a company.
From June 2010, s.254T ostensibly shifted the test for corporate law purposes away from an ‘out of
profits’ test to a test based on corporate solvency (measured by net assets) and fairness between
shareholders.
The clear intent, especially in light of the legislative history, was to abandon the need to identify
whether the company had available ‘profits’ at the time of paying a dividend, or whether any dividend
was being paid ‘out of’ those profits.
However, an opinion by AH Slater QC and JO Hmelnitsky accompanies TR 2012/5 and is to similar
effect based on the arguments that, despite the new s.254T, (i) a doctrine survives in corporate law
that ‘a company cannot distribute its capital in dividends’ and so it is still necessary to establish
whether the company has profits, and (ii) in any event, the rules against returning capital except in
9
accordance with the Act require that a distinction be drawn between capital and profits . That view is
9
http://law.ato.gov.au/pdf/pbr/slater_and_hmelnitsky-payment_and_franking_of_dividends.pdf
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echoed cautiously in Ford’s Principles of Corporations Law which says that, although ‘counsel may
have put that proposition too high,’ ‘the intention [of the amendment] has miscarried, because the new
section is expressed in negative language.
The result of all of this is that the 2010 amendments seem not to have not changed the fundamental
requirement that a dividend can currently only be paid out of profits.
Therefore, we can be reasonably confident that the pools of profits that can support the franking of
dividends and non-share dividends are still aligned.
However, this may not remain the case for long.
Exposure draft corporate law legislation released in 2014 would, if enacted in its current form, expand
the circumstances in which a dividend is paid so that the existence of profits will no longer be
required. And dividends paid from this expanded pool would only be rendered unfrankable if sourced
directly or indirectly from the company’s share capital: s.202-45(e).
This would mean that the pool from which franked dividends can be paid will be larger than the pool
that can support franked non-share dividends.
Hopefully this misalignment is addressed statutorily at the appropriate time.
3.12The ATO ruling experience
Industry practice is to obtain a class ruling setting out the tax consequences to holders of Additional
Tier 1 securities such as CPS and equity notes – but not for Tier 2 securities.
Private rulings may also be obtained for the issuers.
During 2013 and 2014, the ATO issued a total of 12 class rulings in relation to hybrids for issuers in
the FS sector.
Class ruling
Issuer
Instrument
CR 2013/17
Westpac
Westpac Capital Notes
CR 2013/18
NAB
Convertible Preference Shares
CR 2013/46
Macquarie Group
Macquarie Group Capital Notes
CR 2013/55
ANZ
ANZ Capital Notes
CR 2013/93
NAB
Convertible Preference Shares 2
CR 2014/22
ANZ
Capital Notes 2
CR 2014/40
Suncorp
CPS3
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Class ruling
Issuer
Instrument
CR 2014/46
Westpac
Capital Notes 2
CR 2014/80
CBA
PERLS VII Capital Notes
CR 2014/83
Bendigo and Adelaide Bank
CPS
CR 2014/86
Macquarie Bank
Macquarie Bank Capital Notes
CR 2014/87
Challenger
Challenger Capital Notes
That is, each year, the ATO is utilising significant resources ruling on hybrids. Indeed, the ATO has
stated that “the consideration and classification of some hybrid instruments has consumed a
10
disproportionate amount of ATO resources” .
One can sympathise with the ATO: each hybrid issue requires them to review multiple drafts of
multiple transaction documents on a very strict – and often not very generous – timetable.
The ATO has in recent years developed an early engagement rulings process. Most hybrid issuers in
the FS industry have access to that process.
Our experience is that this process works extremely well in that:

there is one central point of ATO contact;

an ATO team is mobilised very quickly;

the teams generally have prior hybrids experience (but see below); and

impressively, the teams uniformly understand the transaction timetable and comply with it –
even when the timetable is particularly compressed.
Importantly, ATO practice is to only issue the class ruling once the hybrid has itself been issued.
However, the ATO does issue draft class rulings before issuers launch the relevant offer document.
The ATO takes the issue of draft rulings very seriously: despite the non-reliance qualification they
contain, the ATO regards a draft class ruling as a final view that is subject only to confirmation of the
facts in light of details of the issue itself. This practice is welcome and is regarded by due diligence
committees as an important risk management requirement.
One relatively minor suggestion has been made to the ATO regarding the allocation of teams. ATO
early engagement ruling teams are assigned to matters on a “cab rank” basis – so that any available
team may be assigned a hybrid ruling application. From time to time this basis means that an issuer
will be assigned a team that is less familiar with hybrids, resulting in a slower process and the need to
resist well-intentioned attempts to tweak what have become industry standard ruling text. Perhaps
the ruling process could be improved even further if hybrid ruling requests were assigned only to a
subset of the total potentially available teams.
10
page 138 of the Board of Taxation debt equity discussion paper
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4 Returning funds to investors
Over the last few years, FS participants have returned significant amounts of funds to their investors.
However, these returns have been largely confined to:
•
•
paying dividends; and
retiring existing hybrids in connection with the issue of new hybrids.
These activities tend not to raise particularly controversial tax issues.
There have been few instances of FS participants returning share capital or non-share capital to
investors over this period. One notable example was MGL’s in specie distribution of approximately
$1.5 billion of SYD securities by way of return of share capital and special dividend. That transaction
is considered further below.
4.1 MGL distribution of SYD securities
4.1.1
Context
MGL had a long-term holding of SYD securities dating back to when MGL had management rights
over SYD.
In late 2013, MGL held around 17% of the issued SYD securities. That holding had a value of
approximately $1.5bn, representing around 5% of the then market value of MGL shares.
MGL had flagged to the market that the SYD securities would be divested at some point.
11
In late 2013, MGL had a strong balance sheet and around $3.1 billion of excess regulatory capital .
12
It was halfway through an announced $500 million on-market buy-back - and under investor
pressure to return capital to shareholders. Moreover, SYD securities had appreciated significantly in
the 18 months leading up to late 2013, from $2.50 to around $4.00.
But how should the divestment take place?
An on-market sale or block sale of a non-controlling stake is typically subject to heavy discounting –
and would have required MGL to make a capital return as a second step anyway.
An in specie distribution was considered preferable because an in specie distribution of securities:
•
tends not to depress the market price of the distributed securities too heavily;
•
was welcomed by vocal shareholders’ associations as an equitable way to distribute
value to shareholders so that they can directly participate in the ownership of SYD – they
11
Page 8 of the MGL Notice of General Meeting released on 1 November 2013 (Notice of General Meeting).
12
Notice of General Meeting page 9
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can then decide whether to sell or hold the SYD securities based on their individual
13
circumstances ; and
14
was expected to increase MGL’s return on equity .
•
And so MGL announced on 1 November 2013 that, subject to shareholder approval, MGL would
distribute 92% of its SYD holding on the basis of 1 SYD security for every 1 MGL share on issue
(Distribution). The remaining 8% was sold separately. MGL shares would also be consolidated under
s.254H of the Corporations Act on a 1:0.9438 basis.
The MGL general meeting held on 12 December 2013 approved the Distribution. The approval rate
was over 99%.
The SYD securities were distributed on 13 January 2014 (Distribution Date).
4.1.2 Overview of tax issues
Demerger relief was not available for the distribution for reasons including that MGL held less than
20% of the issued SYD securities and SYD securities are stapled securities.
The tax issues for MGL shareholders on capital account associated with the Distribution are set out in
CR 2014/10.
In summary, the issues ruled upon are:

inclusion of the dividend component in assessable income, gross up and tax offset;

no application of franking related integrity provisions, including s.177EA;

CGT event G1 applies in respect of the capital component (CGT event C2 for shareholders
who dispose of their MGL shares between the record date and the Distribution Date);

s.45B does not apply in respect of the capital component;

any capital gain is disregarded for foreign resident shareholders;

shareholders get a market value cost base in their SYD securities; and

share consolidation not a taxing point and cost base allocation is required.
The more specific tax issues for participants in various MGL staff remuneration plans associated with
the Distribution are set out in CR 2014/14 – and are beyond the scope of this paper.
Some specific observations on tax issues are set out below.
4.1.3 The dividend/capital split
Overview
Tax is the only discipline that attaches any real significance as to how much of the Distribution is a
dividend and how much is a return of capital - legal and accounting are agnostic.
13
14
CR 2014/10 paragraph 25
CR 2014/10 paragraph 25
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Prima facie, any return of capital reduces cost base while a dividend is assessable/frankable.
This creates an incentive for companies to maximise the return of capital.
However, the allocation as between return of capital and dividend is impacted by the potential
application of s.45B. If triggered, that specific anti-avoidance provision recharacterises some or all of
the capital component as an assessable but unfrankable dividend.
Section 45B can only be triggered if the requisite non-incidental purpose is present. Regard must be
had to the 18 “relevant circumstances” set out in s.45B(8) in determining whether that purpose is
present.
The first of those circumstances is whether the capital return component is attributable to profits
(realised or unrealised) of MGL or of an associate. While there are 17 other specified relevant
circumstances, the ATO regards it as one of the most (if not the most) significant ones.
It was not possible to trace MGL share capital to the SYD securities held by members of the MGL
group.
In those circumstances, the ATO applies a “slice” approach to arrive at what it considers an
appropriate capital component for a distribution: see paragraphs 60 to 76 of PS LA 2008/10. (Note
that this is a different approach than the ATO takes in relation to the capital component of buy-backs
and demergers.)
This involves computing the relative proportions of “capital” and “retained earnings”, then applying
that ratio to the market value of the distributed SYD securities, with that market value determined as
at the Distribution Date (ie, 13 Jan 2014).
Practicalities
How should the capital amount be determined?
MGL’s accounts show a significant difference between its stand alone contributed capital and its
consolidated accounting group contributed capital because of the interposition of MGL between MBL
and its shareholders (ie, the NOHC interposition).
The ATO accepted that the capital amount was the issued capital shown in the MGL stand alone
accounts.
How should the retained earnings amount be determined?
The ATO accepted that it was the retained earnings amount shown in the MGL stand alone accounts.
However, the difference between the stand alone and accounting consolidated retained profit
amounts were not significant – and the ATO may well focus on the accounting consolidated retained
profit amount in different circumstances.
When should the capital and retained earnings amounts be struck?
MGL did not strike accounts as at the Distribution Date. Moreover, it is more digestible for
shareholders to be presented with a particular capital/dividend split when voting on a proposed
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transaction, rather than a formula. Fortunately, the ATO took those issues on board and accepted
that the capital/profit split could be based on the immediately preceding half year accounts, adjusted
for certain items such as intervening dividends received and paid by MGL as well as the Distribution
itself.
When should the market value be struck?
Even where the capital/dividend split is known in advance, it must be applied to the market value of
the SYD securities as at the Distribution Date in order to arrive at the quantum of both the capital and
dividend components.
This would have been pretty straight forward if the SYD Securities were unlisted securities as a
relatively stable market value could be arrived at. This is relevant to MGL to complying with its s.20270 obligation to give shareholders a distribution statement on or before the Distribution Date.
However, the issue was complicated by the fact that SYD securities are ASX listed securities. The
traded price of listed securities is generally seen as a proxy for their market value – but obviously it
fluctuates daily – and intra-day.
Our research did not uncover any examples of distributions of listed securities fixing in advance
either/both the dividend/capital components.
Again, fortunately the ATO took these issues on board and accepted the closing price of the SYD
15
securities on the last trading day before the Distribution Date as their market value .
4.1.4 The nominee structure
Initially SYD was 2 stapled trusts. However, it restructured shortly before the Distribution Date as a
company stapled to a trust.
16
A person can generally only become a member of a company by agreeing to do so .
In order to overcome potential issues in this regard, MGL shareholders were given the ability to elect
to become registered SYD holders. But if a MGL shareholder did not make the election, then MGL
transferred the SYD securities to a nominee to hold on the MGL shareholder’s behalf pursuant to a
nominee deed.
This potentially raises the vexed issue of absolute entitlement (ie, whether the non-electing MGL
shareholders are absolutely entitled to the SYD securities as against the nominee).
The ATO ruled that the nominee arrangements did not produce any tax outcomes different to those
17
applying to electing MGL shareholders .
15
paragraph 45 of CR 2014/10
s.231(b) Corporations Act
17
paragraph 70 of CR 2014/10
16
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4.1.5 TFN withholding from an in specie distribution
The payer of an unfranked or partially franked dividend is liable to deduct TFN withholding in respect
of the unfranked portion of dividends paid to an Australian resident where no TFN has been quoted.
Where a company pays a $100 unfranked cash dividend to a non-quoter, the company simply
deducts and remits $49 cash in respect of its TFN withholding obligation - and is statutorily
18
indemnified for doing so .
However, an specie distribution does not involve cash moving from company to shareholder so the
company cannot deduct an amount of cash from the distribution. Rather, the dividend paying
company has to pay the TFN withholding and only has a statutory right to (separately) recover the
19
TFN withholding amount as a debt from the shareholder . Importantly, the dividend paying company
does not have a statutory right to sell (or retain) part of the property comprising the in specie
distribution to fund its TFN withholding obligation.
It is therefore, important to ensure that the dividend paying company’s constitution gives it such a
power.
4.1.6 Share consolidation
MGL conducted a share consolidation pursuant to s.254H of the Corporations Act.
The consolidation was on a 1:0.9438 basis – reflecting (only) the capital component, estimated as at
30 October 2013.
The ATO accepted – as it did in the similar Wesfarmers transaction
20
– that this involves a merger of
shares rather than the ending of particular shares. Consequently, pursuant to s.112-25(4), there was
no CGT event and what amounts to a cost base apportionment was required.
21
It should be noted that the precise method of apportionment is unclear from the class ruling – whether
a “blended cost base” approach applies or whether the cost base in particular original shares is
transposed directly into the cost base of consolidated shares.
4.2 Share capital tainting
4.2.1 Context
As indicated in section 2.4.4 above, it may be the case that at least some FS participants will look to
rebalance the particular components of their regulatory capital and that there may be CM activities
involving returns of capital (eg, buy-backs).
18
s.16-20 of Schedule 1 to the Taxation Administration Act
s.14-60 of Schedule 1 to the Taxation Administration Act
20
Refer Class Ruling 2013/69
21
paragraphs 71 to 73 of CR 2014/10
19
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A key issue in any transaction involving an element of capital return is whether the company’s share
capital account is “tainted”.
This is because a tainted share capital account is generally taken not to be a share capital account for
tax purposes, with the effect that:

for an off-market share buy-back, the amount otherwise debited to the share capital account
22
will be a dividend for tax purposes ;

for a return of share capital, the amount otherwise debited to the share capital account will
23
also be a dividend for tax purposes ; and

in both cases, the (deemed) dividend will not be frankable as it is sourced directly from the
24
company’s share capital account .
In addition, a franking debit and untainting tax may arise for the company.
These are seriously adverse outcomes.
Yet there is precious little guidance on the share capital tainting provisions. In this regard:

there are only a small number of ATO IDs and edited private rulings on point;

the ATO did issue a useful fact sheet, but it has been removed from the ATO website for
25
reasons that have not been publicly communicated ; and

The ATO has more recently issued a very high level fact sheet .
26
An ATO officer has confirmed that there have been only a handful of instances of untainting tax being
paid since the share capital tainting provisions were reintroduced in 2005.
One has the impression that there is a lot of iceberg lurking beneath the water in this area.
4.2.2 The provisions
The policy background to the share capital tainting rules can be put succinctly:
“… the share capital tainting rules are integrity rules designed to prevent a company from
disguising a distribution of profits as a tax-preferred capital distribution by transferring profits
into its share capital account and subsequently making distributions from that account.”
27
The primary provisions are found in Subdivision 197-A.
The principal provision is s.197-5(1) which provides as follows:
22
Refer s.975-300(3) and s.159GZZZP(1).
Refer s.975-300(3) and paragraph (d) of the definition of dividend in s.6(1).
24
Refer s.975-300(3)(ba) and s.202-45(e).
25
It can still be accessed here:
http://web.archive.org/web/20090817092028/http:/www.ato.gov.au/print.asp?doc=/content/00106952.htm
26
https://www.ato.gov.au/Business/Imputation/In-detail/Simplified-imputation/Fact-sheets/Share-capital-account-tainting/
27
para 4.4 of in the Explanatory Memorandum to the Taxation Laws Amendment (2006 Measures No.3) Bill 2006 (Division
197 EM)
23
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“(1) Subject to subsection (2), this Division applies to an amount (the transferred amount) that
is transferred to a company's *share capital account from another of the company's accounts,
if the company was an Australian resident immediately before the time of the transfer.
As can be seen, Division 197 applies to any transfer to a share capital account from an account that is
not a share capital account. That is, Division 197 is not confined to the capitalisation of profits.
The balance of Subdivision 197-A is made up of transfers that otherwise satisfy s.197-5(1) but which
are excluded from the operation of the share capital tainting provisions.
The categories of excluded transfers are summarised below:





28
transfers of amounts that could at all times be identified as share capital ;
transfers of amounts transferred under debt/equity swaps, subject to a cap;
transfers of amounts on certain companies ceasing to have par value shares;
transfers from option premium reserves; and
transfers associated with certain demutualisations.
The term “share capital account” is defined in s.975-300(1) as:
“(a) an account that the company keeps of its share capital; or
(b) any other account (whether or not called a share capital account) that satisfies the
following conditions:
(i) the account was created on or after 1 July 1998;
(ii) the first amount credited to the account was an amount of share capital.”
Moreover, s.975-300(2) provides that:
“If a company has more than one account covered by subsection (1), the accounts are
taken, for the purposes of this Act, to be a single account.”
4.2.3 Things we are relatively certain about
A number of concepts that are key to Subdivision 197-A are undefined, raising uncertainty.
Nevertheless, we can be relatively certain about the following matters:
29

a “transfer” requires a reduction in one account and an increase in another account ;

“increase both sides” journal entries do not constitute a “transfer” ;

a transfer between two accounts, each of which is treated under s.975-300(2) as part of the
company’s single share capital account is not a transfer to which Division 197 applies;

paragraph (a) of the definition of “share capital account” extends to both:
 a record of a transaction into which the company had entered in relation to the value
provided by its shareholders for the issue of shares; and
 a record of the financial position of the company in relation to the value provided by
31
shareholders for the issue of shares ;
30
28
The example commonly given is the amount subscribed for convertible notes which, before conversion, are recorded in a
liability account
29
Paragraphs 4.12 and 4.13 of the Division 197 EM
30
Paragraphs 4.12 and 4.13 of the Division 197 EM
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32

an “account” is a reference to the accounting concept of a record of debits and credits ;

stand alone company accounts are the relevant accounts (not accounting group consolidated
33
accounts) ; and

the accounting entries expected by ASIC when RPS are redeemed out of profits result in
34
share capital tainting .
However, even where the relevant accounting entries do not prima facie produce share capital
tainting, the ATO practice appears to be to apply a “backstop” approach by asking whether there is a
divergence between the form and substance of the transaction and, if so, whether the substance of
the transaction offends the policy of the provisions.
4.2.4 Some potentially problematic areas
Potentially problematic areas in relation to Division 197 include the following:

identifying precisely which accounts in the equity section of a company’s balance sheet are
(and are not) share capital accounts;

great care in particular must be taken with credit entries in respect of employee share and
35
option plans ;

entries in relation to treasury shares; and

credit entries to the share capital account made in error which are subsequently remediated
through correcting and reversing journals.
4.3 Observations
Many Australian resident FS participants would regard their share capital account as an “asset”. After
all, they would expect that it could support tax deferred capital returns to shareholders. And where
the share capital account has a multi-billion dollar balance, it is a material asset on any view.
However, share capital tainting does not have a purpose requirement nor does it have a de minimis
carve out. The outcomes are binary – either the whole share capital account is tainted or it is not.
And the consequences of tainting a share capital account are draconian.
31
FCT v Consolidated Media Holdings [2012] HCA 55, Ford’s Principles of Corporations Law RP Austin & I M Ramsay 14th Ed,
Butterworths Aust 2010 at [17.100] , Archibald Howie Proprietary Ltd & Ors v. Commissioner of Stamp Duties (NSW) (1948) 77
CLR 143, St George Bank Ltd v. FCT (2009) 176 FCR 424; [2009] FCAFC 62, paragraphs 31 and following of TR 2012/1
32
FCT v Consolidated Media Holdings [2012] HCA 55
33
ATO ID 2009/94
34
https://www.ato.gov.au/Tax-professionals/TP/Finance-and-Investment-Sub-committee-minutes---8-August-2006/?page=12
35
For example, the ATO may no longer hold the views expressed in the private rulings with authorisation numbers 90710 and
1011712550009
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Favourable rulings on returns of capital and buy-backs will only be issued on the basis that the
company’s share capital account is not tainted. This is manifested in the “other relevant matters”
section of every ruling dealing with a capital return or buy-back. The relevant paragraph will be along
these lines:
This ruling is prepared on the basis that immediately before the return of capital/buy-back the
relevant company’s share capital account was not tainted for Division 197 purposes.
A statement to this effect will have been included in the relevant ruling application, which will have
been signed off by the company.
Experience indicates that there is some variation in the degree of rigour applied to issuers’ verification
of these statements.
Best practice in terms of a verification process involves the following steps:

Step #1: identify which of the accounts in the equity section of the head company’s stand
alone balance sheet are (and are not) a share capital account in light of the test described
above.

Step #2: identify all credit entries to the identified share capital accounts – ever.

Step #3: analyse those credit entries and form a view as to whether any tainting has
occurred.

Step #4: calculate and pay untainting tax, if required.
To best ensure that no tainting subsequently occurs (and simplify the verification process for future
capital returns/buy-backs), it is vital that group tax has an approval/supervisory role in relation to any
credits proposed to be made to the accounts identified under step #1. That is, processes should be
put in place so that no such entries can be made without group tax sign off.
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