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Submission No. 182 Back to full list of submissions
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FINANCE AND TREASURY ASSOCIATION

 

RESPONSE TO

A PLATFORM FOR CONSULTATION

Issued – February 1999

Prepared by the Finance and Treasury Association

CONTENTS:

Contacts
Introduction
Executive Summary
Submission Points

CONTACTS

For further information or clarification please contact:

Finance and Treasury Association

Marilyn Forde
Executive Director
Ph: (03) 9629 5544
Fax: (03) 9629 7881
E-mail: mforde@fta.asn.au

Ian Crofts
Technical Manager
Ph: (03) 9629 5099
Fax: (03) 9629 7881
E-mail: ian@fta.asn.au

INTRODUCTION

The Finance and Treasury Association (FTA) welcomes the opportunity to make comment on "A Platform for Consultation". The FTA was formerly known as the Australian Society of Corporate Treasurers (ASCT).

FTA will only be making comment in respect to Chapters 5, 6 and 7 – the Taxation of Financial Arrangements by relaying the experiences and views of treasury and finance practitioners. FTA has actively been involved in consultation with government since The Consultative Document in this area.

FTA acknowledges A Platform for Consultation has outlined some of the proposals and reservations FTA had previously submitted in its submissions to "The Consultative Document" and "An Issues Paper".

FTA endorses A Platform for Consultation for being more receptive to ideas than An Issues Paper was.

The objectives of the FTA are:

  • to be the pre-eminent body representing finance and treasury professionals;
  • promoting excellence in financial risk management;
  • promote the profession of financial risk management and the recognition of its practitioners wherever they are located;
  • to determine the views of members on finance and treasury issues and to communicate those views to government, other industry organisations and to the community generally;
  • to provide forums for members to meet and discuss issues which are relevant to finance and treasury ; and
  • to promote ongoing professional development of members and to improve the availability and standards of education.

EXECUTIVE SUMMARY

 

Transitional Arrangement

FTA submits:

  • The taxation rules apply to those financial assets and liabilities entered into after the commencement date of the rules with an option for taxpayers to bring all their financial assets and liabilities under the new framework.
  • Where a transaction is materially altered after the commencement date; it would be subject to the new arrangements from the date it materially altered.
  • A "balancing charge", similar to what was recommended in the Issues Paper be introduced to facilitate corporates bringing all their financial assets and liabilities under the new framework

Key Policy Issues Relating to Tax Timing

FTA submits:

  • The adoption of a benchmark and reasonableness test should be based and calculated on a portfolio basis and not on each individual transaction.
  • FTA supports the notion of an "exclusion" may be appropriate for less sophisticated taxpayers.
  • A daily compounding accruals method should not be considered.
  • FTA supports Options 3: A combination of approaches.

Is there a need for hedging rules?

FTA submits:

  • FTA recommends that hedge tax accounting treatment be not restricted to only derivatives and foreign currency risk of debt, but be open to all methods of hedging risk.
  • Hedging rules should not expose non-financial institutions to an unreasonably high level of expectations, compliance and "compliance risk".
  • FTA recommends the continuation of the current law in-respect to non-financial arrangements, where the gain or loss on a hedge not be taxed until the corresponding loss or gain on the underlying position is realised. A case in particular is where foreign currency debt which is used as a natural hedge.
  • As an alternative method to the previously proposed inverse correlation test and contemporaneous book keeping, FTA proposes that corporates as a part of the regular review of their Treasury Policy Manual outline their risk management philosophy as well as products that can be used and when. As a part of the normal audit process, a signed auditor’s report would identify the hedges and the corresponding underlying risk as a support for the risk management policy. This will reduce the compliance burden and allow corporates the flexibility of exercising the best practice of managing risk for their organisation’s needs at the same time provide the Government with a high degree of comfort.
  • The treatment of recognising the timing of income and deductibility of option premia, where the option is not exercised needs clarification. FTA’s recommendation is to treat all option premia on a cash basis.
  • The taxation of unrealised gains in respect to foreign currency denominated debt that is not used as a hedge or has not been hedged, and has no carry back provisions is an inappropriate basis to levy income tax as it ignores the concept of realisation.
  • FTA would require the recognition for tax purposes internal hedging for any organisation that has the ability to identify internal hedges and satisfy safeguards.
  • FTA would also require recognising inter-group hedges, that is, extending the previous recommendation to in-house finance companies while the corresponding underlying exposures are within another tax paying entity of the group.

Debt/equity hybrids and synthetic arrangements

FTA submits:

  • The FTA supports a "blanket approach" only after legal form and a relevant focussed "facts and circumstances" approach fails to categorise a hybrid instrument. It would be fair to say financial markets would be willing to trade off hybrid issuance at the margin for certainty.

SUBMISSION POINTS

Specific Comments

Transitional Arrangement (Chapter 5 page 152)

FTA submits:

  • The taxation rules apply to those financial assets and liabilities entered into after the commencement date of the rules with an option for taxpayers to bring all their financial assets and liabilities under the new framework.
  • Where a transaction is materially altered after the commencement date, it would be subject to the new arrangements from the date it materially altered.
  • A "balancing charge", similar to the recommendation in the Issues Paper be introduced to facilitate corporates bringing all their financial assets and liabilities under the new framework

As rightly highlighted in A Platform for Consultation, the application of new rules could impact unfairly on commercial outcomes and could involve significant compliance costs. Therefore, so corporates can bring all their financial assets and liabilities under the new framework, FTA proposes that a "balancing charge" similar to the recommendation in the Issues Paper be introduced. The Issues Paper indicated a balancing charge period of four (4) years. The FTA believes that four years is reasonable in most cases. However, the FTA recommends that in certain cases the Commissioner be granted discretion to extend the balancing period where a taxpayer is clearly committed to an instrument of a longer period. The FTA notes that there are some financial products in the market, which have a period considerably longer than four years.

There would be minimal (and likely to be no) adverse revenue implications associated with allowing individual taxpayers to make an application to the Commissioner for an extended balancing period where it was adequately shown that the taxpayer was committed to the financial instrument prior to the introduction of the proposed regime.

Key Policy Issues Relating to Tax Timing (Chapter 6, pages 157 - 193)

FTA submits:

  • The adoption of a benchmark and reasonableness test should be based and calculated on a portfolio basis and not on each individual transaction.
  • FTA supports the notion tha an "exclusion" may be appropriate for less sophisticated taxpayers.
  • A daily compounding accruals method should not be considered.
  • FTA supports Options 3: A combination of approaches.

How would the proposed timing adjustment apply?

FTA stands by the principle that a "timing adjustment" or "benchmark test" should not lead to onerous taxpayer compliance, and acknowledges A Platform for Consultation recognising this at point 6.5. Therefore, the FTA supports the notion that an "exclusion" may be appropriate for less sophisticated taxpayers.

FTA supports the combined reasonableness and benchmark approach (combination tests) proposed in An Issues Paper which allows the tax payer to use the method used in audited financial statements as well as the timing adjustment approach outlined in "A Platform for Consultation". Both these methods are significant and positive steps away from the daily compounding accruals method outlined in The Consultative Document.

A downside of a reasonableness and benchmark approach would be when it is a requirement to individually assess each financial transaction. For those financial arrangements that differ from the benchmark, lets say by more than 10%, be treated differently (yield to maturity approach). This would require a significant amount of resources and be difficult to document and comply. As regularly mentioned in this submission, best practice is for risk to be managed on a portfolio approach.

Consistent with the concept of best practice, the availability of a "safe harbour of 10%" benchmark on a portfolio basis, (rather than on an individual transaction as proposed by the Issues Paper) would result in minimal (if any) adverse implications to the revenue base and would fit comfortably within the framework of balancing tax payers’ compliance burden.

How would the proposed timing adjustment apply?

FTA supports Option 3: A combination of approaches, for the reasons outlined at 6.55.

Is there a need for hedging rules?

FTA submits:

  • FTA recommends that hedge tax accounting treatment be not restricted to only derivatives and foreign currency risk of debt, but be open to all methods of hedging risk.
  • Hedging rules should not expose non-financial institutions to an unreasonably high level of expectations, compliance and "compliance risk".
  • FTA recommends the continuation of the current law in-respect to non-financial arrangements, where the gain or loss on a hedge not be taxed until the corresponding loss or gain on the underlying position is realised. A case in particular is where foreign currency debt which is used as a natural hedge.
  • As an alternative method to the previously proposed inverse correlation test and contemporaneous book keeping, FTA proposes that corporates as a part of the regular review of their Treasury Policy Manual outline their risk management philosophy as well as products that can be used and when. As a part of the normal audit process, a signed auditor’s report would identify the hedges and the corresponding underlying risk as a support for the risk management policy. This will reduce the compliance burden and allow corporates the flexibility of exercising the best practice of managing risk for their organisation’s needs at the same time provide the Government with a high degree of comfort.
  • The treatment of recognising the timing of income and deductibility of option premia, where the option is not exercised needs clarification. FTA’s recommendation is to treat all option premia on a cash basis.
  • The taxation of unrealised gains in respect to foreign currency denominated debt that is not used as a hedge or has not been hedged, and has no carry back provisions is an inappropriate basis to levy income tax as it ignores the concept of realisation.
  • FTA would require the recognition for tax purposes internal hedging for any organisation that has the ability to identify internal hedges and satisfy safeguards.
  • FTA would also require recognising inter-group hedges, that is, extending the previous recommendation to in-house finance companies while the corresponding underlying exposures are within another tax paying entity of the group.

The FTA supports the adoption of hedging rules within a framework for financial arrangements, only if the rules are practical and workable, that is, the rules do not expose corporates to an unreasonable high level of expectations, compliance and "compliance risk" as the regime proposed in An Issues Paper would have. Despite the regime in An Issues Paper having some practical shortcomings, the recommendations in "The Consultative Document" should not be considered.

Previous work in the area of hedging rules has restricted the application of these rules to derivatives and risks associated with foreign currency debt. The FTA requests if hedging rules are to be developed the rules accommodate a wide range of commercial risk management activity.

On the issue of identifying hedges in a portfolio of risks the latest risk management software does have fields for coding of transactions which can be used to identify whether a transaction is hedging a financial or non-financial risk and by what proportion. However, such software packages are generally cost prohibitive and used only by larger corporates and fund managers. The results from FTA, Ernst and Young and ANZ 1996 Corporate Treasury Survey illustrate this. The results of the survey showed:

  • spreadsheets remain the predominant method for recording transactions and undertaking exposure analysis, followed by packaged systems;
  • 40% used spreadsheets, less than 10% used manual ways, around 20% had developed an in-house system, around 30% had bought a packaged system; and
  • 56% of all respondents to the survey stated that their treasury system was not able to accommodate all treasury instruments.

The notion of inverse correlation as a cornerstone for hedge treatment is well established in accounting standards and on face value is a reasonable approach to be adopted for tax purposes. On the whole, most corporates enter into financial transactions for funding, liquidity and hedging purposes (either pro-active or reactive hedging). The FTA, Ernst and Young and ANZ Corporate Treasury Survey support this.

That is, 92% of non-financial industry treasuries do not rely on actively trading to boost profit. The survey is supported by anecdotal evidence of little or no trading of treasury instruments by non-financial institutions.

The decision not to trade is often encompassed in an organisation’s Treasury Policy and Procedures Manual, therefore, removing the latitude or motivation to trade or realise transactions to suit a desired tax result.

The problem with the inverse correlation test is the subjectivity of what a high degree of inverse correlation actually constitutes and how is it to be measured? In reality there are many different instruments to hedge risk with. While inverse correlation between the hedging instrument and the underlying risk is a major factor in choosing an appropriate hedge, there are other considerations like liquidity, "spreads" and efficiency.

It is not unusual to hedge a long term fixed rate interest rate exposure with the next 90 day Bank Bill Futures contract or by a Bank Bill Futures strip instead of a 3 year or 10 year Bond Futures contract. As well as interest rate swaps agreement which do have a higher degree of inverse correlation with a long-term fixed interest rate exposure. The corporate values the greater liquidity of the next Bank Bill Futures contract and the greater safeguards of an exchange traded futures market more than the less liquid bond contracts or the "less safe" over the counter derivatives market.

A corporate that has receipts in many different Asian currencies may sacrifice some degree of inverse correlation by not hedging each currency individually, but instead use a more liquid currency or a "cocktail" of liquid currencies as a proxy hedge. The gains associated with higher liquidity and therefore tighter pricing and efficiencies from a portfolio approach are greater than the degree of possible loss from less inverse correlation.

Therefore, before developing hedging rules, what is outlined below would need to be carefully considered.

  • An inverse correlation test should not be prescriptive to shackle a corporate into choosing the hedging instrument with the highest level of inverse correlation. Therefore, finance executives should have the flexibility to choose the hedging strategy that best suits their needs.
  • This would then raise the question of how to measure inverse correlation?
  • Would the maturity dates or repricing dates of the underlying risk and the hedging instrument have to match to constitute correlation? Dates do not always match, as it can be hard to achieve good pricing for exact dates as well as forecasting anticipated cash flows with one hundred percent accuracy.
  • Correlation is not a linear relationship and can change over time. What if correlation between a hedging instrument and the underlying position deteriorates, would that existing hedge transaction lose its hedge rules treatment?
  • If a more efficient hedge emerges and the original hedge was terminated early, how would the original hedge be treated? It would be unacceptable for tax laws to interfere with pro-active risk management.

As a majority of Australian corporates do not enter into trading activities, the motivation to manipulate transactions to take advantage of the hedging rules would not be common. It therefore follows, an inverse correlation test will just burden corporates with a high level compliance and "compliance risk" for no significant revenue gain to the Government.

The same burdens and logistical limitations of an inverse correlation test would also be imposed on corporates if contemporaneous record keeping were required. The FTA recognises the need for documentation and identification, however, what was proposed in An Issues Paper would be unreasonable. That is, to document all hedging transactions to the degree outlined in An Issues Paper. Corporate Treasury Risk Managers would spend a lot of their time documenting rather than pro-actively managing risk. The outcome of this would be treasury functions having to employ more risk managers or expose the corporate to greater risk as the risk manager is now in a position to less pro-actively manage risk.

To provide the probable level of comfort of revenue protection required by the Government, FTA recommends that an auditor’s report as part of the company’s identification program for hedge instruments and as support for the Risk Management Policy. Risk Management Policy is a proprietary issue, therefore hedge tax treatment rules should be flexible enough to respect management decisions.

The ability to automate the identification and details of a hedge would only be in the realm of large corporates. An Issues Paper proposed, that taxpayers would have to document at the time of the transaction is entered into to qualify for hedge treatment. In practice this will be very difficult for most large corporates with a large number of derivatives used for hedging. The FTA would recommend that an identification period of 30 to 60 days be provided to allow an internal treasury sufficient time to identify the hedge. This policy would also be consistent with current internal management reporting practices.

In the case of anticipated transactions, and as mentioned beforehand, corporates do not as a general rule enter into trading activities, the motivation to manipulate transactions to take advantage of the hedging rules is therefore not widespread. For the reasons outlined in great detail above (inverse correlation test and contemporaneous book keeping), what is considered in A Platform for Consultation at 6.69 is not appropriate for corporates.

That is to say by default, corporates would only enter into an anticipated transaction if there were a high degree of probability it will enter into a transaction giving rise to a risk. A better approach would be including in a corporate Risk Management Policy the treatment of anticipated hedge transactions.

As an alternative method to an inverse correlation test and contemporaneous book keeping, FTA proposes that corporates as a part of the regular review of their Treasury Policy Manual outline their risk management philosophy as well as products that can be used and when. As a part of the normal audit process, a signed auditor’s report would identify the hedges and the corresponding underlying risk as a support for the risk management policy. This will reduce the compliance burden and allow corporates the flexibility of exercising the best practice of managing risk for their organisation’s needs and at the same time provide the Government with a high degree of comfort.

The existence of a Treasury Policy Manual and appropriate senior level approval and Board reporting is very high. The results of the 1996 Corporate Treasury Survey showed:

  • 68% of survey respondents indicated the existence of a policy manual approved by the Board.
  • By asset size, percentage of usage of Treasury Policy Manual: <$50m, 50%; $50m- $100m, 50%; $100m - $500m, 58%; $500m - $1b, 65%; $1b - $2b, 76%; $2b - $5b, 73%; and >$5b, 100%; and
  • 77% of respondents provide a risk management report to the Board on a monthly basis with 13% reporting less frequently.

For example, the Treasury Risk Management Policy could explicitly enunciate:

  • Foreign exchange risk should never be completely hedged by one type of derivative.
  • Only foreign exchange forwards and over the counter options shall be used.
  • The writing of options shall be restricted only to collar strategies.
  • For foreign exchange risk past 12 months only foreign exchange forwards can be used.
  • Due to liquidity constraints of some Asian currency derivatives, Singapore dollar derivatives can be used as a proxy.

In the course of normal business activity where an unusual hedging transaction is required or new hedging techniques or product has been developed, the Treasury Risk Management Policy would be updated between regular reviews.

FTA promotes the adoption of an approved Treasury Policy and Procedures Manual with regular reviews for all corporates.

With the disclosure requirements of AASB1033 Accounting Standard, this will provide additional framework for all corporate treasuries to have a documented detailed risk management policy with the appropriate senior level reporting and approval processes. Auditors in their duty of enforcing standards of disclosure, be also required to examine hedging activities of the corporate were consistent with their Risk Management Policy.

An Issues Paper proposed different tax treatment of the hedge depending on whether the underlying transaction was a financial instrument or not. FTA seeks the hedge approach requiring "the tax treatment of financial arrangements that is a hedge to be determined by reference to the tax treatment of the transaction being hedged" to be extended to include the hedging of non-financial assets.

FTA recommends the continuation of the current law in-respect to non-financial arrangements, where the gain or loss on a hedge not be taxed until the corresponding loss or gain on the underlying position is realised.

Often it is very difficult to achieve good pricing or there is no market for longer dated hedging instruments. This is very often the case in non-Hong Kong, Singapore and Japanese Asian currencies. Therefore, a risk manager has the only option in a number of cases of hedging the foreign exchange risk of a non-financial arrangement out to a maximum 180 days and in many cases only 90 days. In this example, if the risk manager wanted to hedge the risk for two years, it can only achieve this by doing a series of rolling hedges every 90 or 180 days. On the other hand, a risk manager with U.S. dollar exposure on non-financial arrangement can obtain very good pricing past one year and be able to enter into the hedge transaction.

Previous work, in particular An Issues Paper discriminated against organisations that may have exposure in less liquid currencies by exposing them to accelerated tax liabilities. FTA requires taxpayers be treated the same as each other.

In respect to general hedges and breaking down the underlying risk exposure hedged by a general hedge into its non-financial and financial arrangements will be imposing and complex and would result in large compliance requirements on corporates, a majority of who would not be in a position to be able to carry it out. As mentioned above, the ability to run exception reports and special coding is the domain of large corporates.

Alternatively, a reasonable benchmark level should be allowed to approximate the underlying portfolio.

An issue the An Issues Paper did not address was the treatment of option premia i.e.: swaptions, in either hedging of financial or non-financial arrangements, when the option is not exercised. Accruing the option premium is not the answer as there may not always be an underlying risk position to accrue the premia. This would need to be addressed. FTA’s recommendation is to treat all option premia on a cash basis.

This would also address the complications that would arise from treating the option premia if the hedge was closed out early.

The negative impact of taxing unrealised gains is no better illustrated than what is proposed in An Issues Paper for foreign currency debt that is not used as a hedge or that has not been hedged. The impact of such a proposal was further compounded by not allowing carry back provisions.

The treatment of foreign currency denominated debt that is not used as a hedge or that has not been hedged will have the effect of making taxable income more volatile and therefore creating associated cash-flow difficulties. The effect of taxing unrealised gains or losses with no carry back provisions is likely to adversely affect the ability to manage franking accounts. Correspondingly, a company exposed to fluctuations in its franking account because of unhedged foreign currency denominated debt may suffer adverse share price fluctuations.

FTA rejects the notion to tax foreign currency denominated debt on a realised basis if it is a natural hedge of a non-financial arrangement. To identify whether or not a foreign currency denominated debt is a hedge or being hedged is in the realm of all corporate treasuries. The proposed position appears inconsistent with the general theme of An Issues Paper. That is, financial instruments should be treated for tax purposes in accordance with their stated and intended "purpose". In denying a taxpayer to differentiate between foreign currency denominated debt for different purposes FTA is concerned that unnecessary inequities will arise for many corporate taxpayers. Accordingly, FTA considers that foreign currency debt, which is used as a natural hedge, should be provided with hedge treatment under the proposed hedging regime.

FTA proposes where a corporate is required to recognise foreign denominated debt on an unrealised basis, carry-back provisions should be available to smooth out fluctuations. FTA notes that such carry back provisions are common in other jurisdictions and involve minimal adverse revenue implications to the revenue authorities.

As noted in An Issues Paper "Financial Institutions usually segment their treasury function into a specialised business unit or units", but this is also quite common within large non-bank groups striving for efficiency and reporting gains. Consequently, two sides of an internal deal could use different accounting methods within non-banks as well.

The safeguards outlined in A Platform for Consultation in Appendix D appear to be more than sufficient and to comply with would not impose the application of a great level of resources. Corporates that use internal deals would be expected to be the same ones who have treasury systems capable of identifying such deals. As a part of the normal audit process, a signed auditor’s report should be sufficient to identify the internal deals and check to see the deals comply with safeguards.

An Issues Paper did not specifically address the issue of providing hedging regime treatment to a group of companies that centralise and manage their risks within a separate group member (in-house finance company) or within the parent company. Managing the risk of different business units or divisions within one central location so as to obtain efficiency and management gains is quite common. So is managing the risks of corporate group members, for the same reasons. Often a financial risk of one corporate group member can offset the risk of another group member, therefore it is good practice and corporate governance to centralise the collection and management of risks. The centralisation of risks can occur either in an Australian or international context. Also, the in-house finance company in most cases receives only the net positions from the other tax paying entities of the group.

The FTA would recommend that corporate groups identify the internal function by supplying a list of inter-group companies and the company where the group risk is managed. This would be included in the group’s Treasury Policy and Procedure and Risk Management Manual.

FTA would like to comment that the International Accounting Standards Committee recently issued accounting standard IAS 39, Financial Instruments: Recognition and Measurement. "A Platform for Consultation" at C.4 and C.5 acknowledges a Joint Working Group has been established to produce an accounting standard on the recognition and measurement of financial instruments and Australia may adopts its recommendations.

FTA outlines below examples of the incompleteness and possible consequences of IAS 39, if it were to be adopted in Australia.

  • IASC 39 states that an option written by an enterprise can not be a hedging instrument unless it is a part of a "covered option". In practice, as a part of a portfolio risk management approach, for enterprises that are commodity producers, it is not unusual to find instances of written or "short options" that are not a part of a "covered option" strategy. At the time of entering into a "short" option position, these enterprises have recognised there is an underlying cashflow (i.e.: future receipts from gold sales) and are comfortable with the risk in return for the collection of the premium. This methodology can meet the criteria for an effective hedge and it would be inconsistent for it not to be recognised as such.
  • Also, the receipt of a net premium does not have to equate with greater risk, but can be due to the enterprise forgoing a calculated and comfortable level of potential gain or upside.
  • IASC 39 proposes that gains and losses resulting from marking to market of anticipated cash flow hedges to be recorded against equity and when the underlying transaction is realised to be put through the profit and loss statement. This does not provide a suitable accounting treatment for the reasons outlined below:
  • It is contrary to the well accepted Australian GAAP treatment of recognising "gains and losses" from cash flow hedges at the time the underlying hedged item is recognised in the financial statements. While not perfect, it is preferable to what is proposed in IASC 39.
  • The current disclosure requirements of AASB 1033 are sufficient, as the gains and losses associated with "fair valuing" these hedges are disclosed in the notes to the accounts. Also, there are the optional disclosures available to enterprises in AASB 1033. Disclosing "gains and losses" in this fashion does not lead to volatility and the distortions associated with E62.
  • The proposal lacks symmetry as the gains or losses of the hedges are only being recorded and not the offsetting gains or losses associated with the underlying hedged transaction. Therefore, if an unrealised loss on the hedge is passed through equity, equity is artificially deleted while the enterprise has not suffered any economic loss, just an opportunity loss.
  • The potential volatility in equity could have major implications for an enterprise’s borrowing covenants. For example, a negative pledge borrowing structure, where the borrower is obliged to have a minimum debt to equity ratio.

Debt/equity hybrids and synthetic arrangements (Chapter 7, pages 197 - 212)

FTA submits:

  • The FTA supports a "blanket approach" only after legal form and a relevant focussed "facts and circumstances" approach fails to categorise a hybrid instrument. It would be fair to say financial markets would be willing to trade off hybrid issuance at the margin for certainty.

FTA welcomes symmetrical tax treatment for issuers and investors when an instrument is recategorised.

FTA supports a "blanket approach" only after legal form and a relevant focussed "facts and circumstances" approach fails to categorise a hybrid instrument. It would be fair to say, financial markets would be willing to trade off hybrid issuance "at the margin" for certainty. That is to say, issuers would want certainty when going to the market. Also, investors would want the same level of certainty when considering buying a hybrid instrument.

As mentioned above, The FTA supports a focussed and relevant "fact and circumstance" test and not the one proposed in An Issues Paper. The FTA could not agree with An Issues Paper’s high weighting to repayment of investment, stipulated return, non-contingent payments, participation in gains and losses, priority of wind up, and ownership and control. The FTA agrees with A Platform for Consultation’s summary at 7.17.

In arguing against the weightings outlined in An Issues Paper the FTA would like to bring to your attention the following.

While the main factors are generally important in ascertaining the nature of an instrument, in practise, it is highly unlikely that a party will wish to take a debt risk in consideration for a debt return unless the lender has certainty with respect to:

  • timing of repayment;
  • the amount of repayment
  • income cash-flows or overall rates of return.

In this respect it is the "other factors" set out in "An Issues Paper" pages 74 – 80 and A Platform for Consultation’s 7.16 that are essential in determining debt from equity. That is, such factors as redemption (automatic or at the holders option); security; guarantees; letters of credit; put options; and significant retained earnings are absolutely critical in ascertaining whether an instrument has the character of debt or equity.

The features of security, guarantees, letters of credit etc are in fact the machinery in which the main factors are enforced. FTA is concerned that this fundamental tenant in distinguishing debt from equity is not properly highlighted. It appears inconsistent with established concepts that non-redeemable, cumulative preference shares with fixed dividend rights could be considered to be debt (as suggested in An Issues Paper) unless the instrument is supported by some of the "other factors". Such instruments would, in normal circumstances, carry those risks which are normally attendant to instruments of equity (not, as suggested, by An Issues Paper, as instrument of debt). However, if such an instrument was backed by a letter of credit with a put option which guaranteed an effective yield to the holder the instrument would be more likely to carry the characteristics of debt rather than equity.

In addition, "An Issues Paper" differentiates the treatment of non-redeemable preference shares with fixed dividend rights solely on the basis if they are cumulative or non-cumulative "because the initial investment is expected to be recouped". On a forced wind up of a company, the implications and benefits as to whether the non-redeemable preference shares were cumulative are, more or less, insignificant. So to differentiate the two on such an event (initial investment is expected to be recouped) indicates a high level of subjectivity and uncertainty of weighting the proposed factors.

In light of the above analysis, it is clear that the debt test needs to reconsider the importance of the "other factors" before classifying an instrument as debt for taxation purposes.

Preference shares are primarily used for their flexibility and to improve the balance sheet of a company. An example of improving balance sheet strength was Westpac in 1993 issuing fully franked preference shares for tier 1 capital when its balance sheet suffered from a high exposure to bad debts. In this situation, fixed dividend preference shares highlight the need for such instruments in the market to encourage subscription to capital which may not otherwise have been be available.

An example of flexibility is the use of redeemable preference shares in joint ventures particularly within the mining industry. This allows equity contributors in large-scale projects to agree and assign risk entitlements and reward. Further, when restructuring equity it is much easier to cancel preference shares than ordinary shares.

In respect of the classification of debt and equity it is worth noting the following considerations:

  • Dividends on preference shares are payable after tax and interest, unlike interest on debt which is paid before tax.
  • If there are no profits there may be no dividend on preference shares. Profitability is not a prerequisite for interest to be paid to the debt holders. However, under An Issues Paper’s proposed approach, if such an instrument were treated as debt, the holder would be required to recognise "interest" income on an accrual basis. This is despite the fact that the company may not return a profit on which to pay the holder of a preference share. Effectively, the current proposals could lead to the holder of such instruments having a current year tax liability on "income" which may never become payable to the holder.
  • In the winding up of a company the holders of debt instruments rank in priority to holders of preference shares.
  • Preference shareholders can have voting rights, however, debt holders do not.
  • If the dividend is not fixed, preference shareholders can participate in increased dividends from increased profits, debt holders do not; and
  • The performance of preference shares is closely correlated with the price of the ordinary shares of the company and the underlying stock market.

As rightly acknowledged in A Platform for Consultation at 7.25 but dismissed by An Issues Paper legal form is not necessarily irrelevant when categorising hybrid instruments.

Therefore, FTA supports legal form as the starting point for determining debt or equity tax treatment. The instrument then could be recategorised based on a relevant and focussed "facts or circumstances test". The weightings given to each determinant of the "facts and circumstances test" be consistent with the arguments above that highlighted the flaws in "An Issues Paper". If the "facts and circumstances test" still failed to categorise a hybrid instrument, a default or blanket approach would come into play. The "blanket approach" determination would be legislative. The taxpayer could then ask for a determination or ruling is they were still unsatisfied.

The FTA welcomes the proposal in "A Platform for Consultation" at 7.30. That is the after an instrument has been recategorised, the taxation treatment for the holder and the issuer should be symmetrical. "An Issues Paper" rejected symmetrical taxation treatment.