St George unable to claim deduction for interest on funding arrangement
On 11 April 2008, the Federal Court, in St George Bank Limited v Commissioner of Taxation [2008] FCA 453, held that St George Bank Limited (SGB) was not entitled to claim a deduction for interest paid on subordinated debentures that it had issued to a Delaware-USA incorporated subsidiary company, St George Funding Company LLC (LLC). The key facts of the case are outlined below.
In 1997, SGB merged (by a scheme of arrangement) with Advance Bank Australia Limited (Advance) by acquiring all the issued ordinary share capital in Advance.
- As a result of the acquisition, SGB was required to raise capital to continue to satisfy the regulatory capital requirements of the Reserve Bank of Australia (RBA), satisfaction of which was a condition of SGB holding a banking licence.
- Under the arrangement to raise capital, LLC was established and capitalised in the amount of US$107.2 million by share subscription of common stock held by two wholly owned subsidiaries of SGB. LLC then issued preference stock (Capital Securities) in the US market in the amount of US$250 million.
- LLC then lent US$350 million to SGB under an indenture (the Indenture), and a debenture (the Debenture) was issued by SGB to LLC. LLC was obliged to use the combined proceeds from the issue of the common stock to the two wholly-owned subsidiaries of SGB and the Capital Securities to purchase the Debenture.
- Interest payment dates on the Debenture coincided with the dividend payment dates for the Capital Securities, and the interest rate on the Debenture equalled the dividend rate on the Capital Securities.
- If principal or interest was not paid on the Debenture, payments of dividends or return of capital were not required to be paid on the Capital Securities. Additionally, the interest payable on the Debentures was effectively deferrable since interest received by LLC on the Debentures was to be returned to SGB (via the payment of dividends by LLC to the common stockholders) where the dividends on the Capital Securities were not payable under the terms of the issue.
The Debenture was an unsecured, subordinated obligation of SGB ranking “junior in right of payment to prior payment in full of all claims of other creditors”.
A further matter relevant to the case was whether a valid election had been made by SGB pursuant to item 118(6) (b) of Schedule 1 of the New Business Taxation System (Debt and Equity) Act 2001 to invoke the debt and equity provisions of the tax law in respect of the interest (i.e. the Debenture) which was issued before 1 July 2001 being the start date of the debt and equity provisions. If an election had been validly made, the relevant issue appears to be whether from 1 July 2001, payments made on the Debenture were ‘non-share dividends’ on an ‘equity interest’, since ‘non-share dividends’ are specifically excluded from deductibility under a provision of the tax law, even if the relevant payments would otherwise be deductible under the general deduction provision of the tax law.
It is the deductibility of payment of interest on the Debenture for the 1999 to 2003 income years that is the subject of the case.
The Federal Court held that the payments of interest were outgoings of capital or of a capital nature, and thus were not deductible under the general deduction provision of the tax law. In addition, the Court found that no valid election had been made to apply the debt and equity provisions from 1 July 2001, although the fact that, as determined by the Court, the general deduction provision of the tax law did not authorise a deduction for the interest paid on the debentures meant that whether or not a valid election had been made is somewhat academic.
In holding that the interest paid was capital or of a capital nature, Justice Allsop held that the advantage sought and obtained by the interest payments was “not the cost of acquiring or maintaining an ephemeral loan from interest period to interest period, but a cost of acquiring and maintaining the structural advantages sought by the capital raising, as the means of funding the payment of the dividends on the Capital Securities”. In reaching this conclusion, Justice Allsop’s starting point was the landmark judgment of Justice Dixon in Sun Newspapers Limited v The Federal Commissioner of Taxation; Associated Newspapers Limited v The Federal Commissioner of Taxation [1938] HCA 72. In referring to that judgment, His Honour noted that the chief, if not the critical factor in determining the character of what was paid is the character of the advantage being sought. In this respect, Justice Allsop said that in determining the character of the interest payment as either capital or as revenue, the whole business and legal context of what is being done needs to be taken into account. This includes a consideration from a business and practical perspective, giving adequate weight to the nature of the rights and obligations of the parties created by the relevant transaction documents.
An important observation made by Justice Allsop was that, whilst interest is usually deductible because it is a recurrent or periodic payment securing a non-enduring advantage being the use by the borrower of the money during the term of the loan, as was said by the High Court in Steele v Deputy Commissioner of Taxation 197 CLR 459 at 469-470, “there may be particular circumstances where it is proper to regard the purpose of interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature”.
Justice Allsop rejected the taxpayer’s argument that the characterisation of the advantage that was obtained by the payment of interest must be limited to the maintenance of the loan. He instead concluded that the advantage sought from the periodic interest payments was the maintenance of a loan as an integral part of the expansion and strengthening of the taxpayer’s and its group’s capital standing, and to satisfy the relevant capital adequacy ratios for purpose of the taxpayer being able to retain its banking licence. On this point, it is relevant to observe that Justice Allsop found that under the terms of the arrangement, “it was within SGB’s power to ensure that the loan funds repaid by it to LLC never left the (SGB) Group, by ensuring that holders of the Capital Securities had no right of redemption of these securities”. The mechanism to achieve this outcome was that the proceeds of redemption of the Capital Securities were to be mandatorily applied to the subscription of new shares.
With the substantial amount of tax involved, it is anticipated that the decision will be appealed.
Time running out to fix Division 7A mistakes
Private companies and shareholders are reminded that they only have until 30 June 2008 to ‘self-correct’ certain exposures under the deemed dividend rules in Division 7A of the Income Tax Assessment Act 1936, in line with ATO Practice Statement PS LA 2007/20. The types of exposures and the means of ‘self-correction’ were generally described in our July 2007 edition of TaxTalk, however the circumstances of each case need to be taken into account to ensure that the action taken fully corrects the exposure. From 1 July 2008, taxpayers who have Division 7A exposures because of an honest mistake or inadvertent omission will be required to formally request the exercise of the Commissioner’s discretion to allow the exposure to be corrected. Whilst the Commissioner’s decision must be made in accordance with law, taxpayers should approach compliance with Division 7A on the basis that the exercise of the Commissioner’s discretion will likely be the exception rather than the rule.
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