Tax Brief - Even More Non-Deductible Interest

On 14 September 2004, Justice Hill in the Federal Court handed down the long-awaited decision on the treatment of payments made under Macquarie Bank’s Income Securities.  The decision continues the unhappy trend of taxpayers being denied deductions for interest expense.  It will give pause to others who have similar products on issue; it may have a bearing on the interpretation of the new debt equity regime; and may survive as an impediment to future transactions which do not fall neatly within the classes of instruments created by those rules.

Background

In late 1999 Macquarie Bank Ltd and one of its subsidiaries, Macquarie Finance Ltd, lodged a prospectus with ASIC detailing the proposed offering of “Income Securities” to raise up to $200 million.  It was an important feature of the capital raising that the arrangement would be treated by regulatory authorities as Tier 1 capital. 

An Income Security was in legal form a stapled arrangement comprising:

• a preference share in Macquarie Bank, and
• a perpetual note issued by Macquarie Finance.

The issue in the case concerned the deductibility of the interest incurred by Macquarie Finance on the notes.

So far as the notes were concerned, the terms of the issue provided:

• Investors would be entitled to receive quarterly interest payments on the notes;
• The interest rate was based on a floating rate plus a premium, with a minimum of 7.25% per annum for the first four years;
• However, the amount of interest payable on the notes could not exceed the distributable profits of Macquarie Bank; and
• The notes were “perpetual” in the sense that the holder of the note could not require Macquarie Bank or Macquarie Finance to repay the amount invested.  However, the stapled securities were listed and could be easily traded by investors, and Macquarie Bank had the right to repurchase the stapled securities.

No dividend was to be payable on the preference shares unless various circumstances arose.  Most involved the insolvency of Macquarie Bank or Macquarie Finance or failing certain capital adequacy requirements.

The arrangement also contained two special terms – referred to as the “payment direction” and the “procurement agreement” – which were designed to satisfy prudential requirements to ensure that, in the event of insolvency, holders of Income Securities would not rank as creditors of Macquarie Bank, but rather their investment would be represented by the preference share.  These two terms would prove significant in the judgment.

The Commissioner had issued a Public Ruling in 2002 saying that he would deny deductions for interest claimed on a similar arrangement.  It was not surprising therefore when he disallowed a deduction of $27.8 million claimed by Macquarie Finance for the interest payable on the notes. He did so on 4 separate grounds.  He argued:

• The interest incurred by Macquarie Finance was not allowable because it was not incurred in carrying on Macquarie Finance’s business;
• The interest incurred by Macquarie Finance was not allowable because it was an outgoing of a capital nature;
• Special rules about convertible notes applied which denied the deduction; and
• The general anti-avoidance rule in Part IVA would apply to deny the interest deduction.

Deductibility Under General Tax Principles

The Commissioner’s first argument was that Macquarie was not entitled to a deduction because it was raising finance not for the purpose of its own activities, but rather at the behest of, and for the purposes of, its parent, Macquarie Bank. Justice Hill rejected this argument on the evidence.

The more difficult aspect of the judgment focuses on whether the interest payments were capital in nature. The judge reviewed the general rules about the deductibility of interest expense and noted that in some circumstances interest could be on capital account. Whether payments were deductible, would not, he said, be determined by whether the payments were called “interest”, but rather by whether the payments satisfied the general criteria for deductions.

The judgment emphasises the fact that the Income Securities were a stapled note and share.  Macquarie had argued that the two instruments should be analysed separately and not as a single ‘composite’ investment, and the judge acknowledged that if the Income Securities were looked at separately, the legal obligation of Macquarie Finance seemed to have the characteristics of interest on a loan. But the stapling made all the difference in his view – it changed the nature of the arrangement from one which secured the temporary use of funds to something much more permanent.  He noted that the investors could never call for repayment of the notes, were not formally creditors, and had no rights to sue for interest owed.  He also noted that the interest was dependent on Macquarie Bank having distributable profits.  He concluded,

“(t)he close relationship between the notes and the preference shares, as well as the fact that [Macquarie Bank] can ensure that the loan is never repayable but that an investor is left commercially only with [Macquarie Bank] preference shares, can be seen to produce a different result. The present case is not concerned with the cost of acquiring or maintaining a loan of an ephemeral character, but rather with the cost of a capital raising which so far as [Macquarie Bank] is concerned is the cost of a permanent injection of capital.” 

Comment

The judgment delivered in this case is perplexing.  It is clear that Macquarie had borrowed funds.  It had on-lent the funds and derived interest income in excess of the interest cost.  And yet the interest was non-deductible. 

At one point in the judgment the judge appears to base his conclusion on views about why dividends are not deductible.  At other places in the judgment, he appears to base his conclusion on views about the longevity of the capital raised by the transaction.  Which of these analyses is actually applied in the end is not clear.  And if it is the second, it is hard to reconcile that proposition with other passages in the judgment where the judge says that interest on perpetual debt would not necessarily be non-deductible.

A Convertible Note?

The judge held against the Commissioner’s argument that the arrangement amounted to a convertible note for the purpose of the special rules which applied at the time, given that the shares had been issued on a fully-paid basis from the outset of the transaction.

Part IVA

Finally, the judge considered the Commissioner’s Part IVA argument.  His Honour spent a great deal of time grappling with the High Court’s judgment in the Hart case [see our Tax Brief of 30 May].  He considered that he was bound to look to the particular form of the capital raising employed – the issue of preference shares and notes. The judge found the procurement agreement and payment direction were only explicable by reference to the twin aims of obtaining the benefit of Tier 1 capital raising and an allowable interest deduction.  He concluded the scheme took the form it did to allow at least one company in the group – in this case Macquarie Finance – to obtain the tax deduction.  He concluded that Part IVA would have applied if the interest were otherwise deductible.  But His Honour was apparently unhappy with this conclusion.  He went on to say,

“I might add that I reach this conclusion with some reluctance. I doubt if the legislature would have regarded the present "scheme" as involving the application of Part IVA when the Part was enacted in 1981. However, it seems to me that the approach of the High Court in Hartrequires me to reach the conclusion I have.”

Comment

The general treatment of Income Securities has, since 1 July 2001, largely been governed by the “debt/equity provisions” in the Act.  If the Income Securities were issued today it is clearer that the instruments would be treated as giving rise to an equity interest for tax purposes so that no deduction would be available to Macquarie for payments of interest.  Explicit rules exist to allow the consolidation of separate related instruments and one lasting aspect of the case may be to create a parallel instance where instruments can be connected, even when those rules are not triggered.

Even so, we have probably not heard the last word on this topic.  Other institutions have similar instruments on issue.  Macquarie may yet appeal the ruling. 

The enduring concern is that this decision will have an ongoing relevance to payments on instruments that do not neatly fall into the classes created by the debt equity rules.

For further information, please contact,

Mark Ferrier
61 2 9225 5968
mark.ferrier@gf.com.au
www.gf.com.au