Loan Capital and Share Capital
16.145. In the discussion of the present separate system of taxing company profits, attention was drawn to the fact that the system is not neutral as between equity finance and debt finance. This want of neutrality will be less if the partial imputation system proposed by the Committee is adopted; it will virtually disappear under full imputation.
16.146. However, even under partial imputation it would be possible to achieve neutrality if the treatment of loan capital were brought into line with the treatment of share capital. Interest on loan capital would be denied deduction, and imputation would be allowed of part of the resulting increase in company tax. The debenture-holder would be given a credit for the tax imputed against the tax on the interest he receives, in the same manner as credit is given to a shareholder against tax on dividends he receives. It would obviously not be appropriate to extend the treatment to all interest. A company engaged in, for example, banking could hardly be denied a deduction for interest paid on deposits, nor could a company which was a customer of the bank be denied a deduction for interest paid to the bank on its overdraft. There would be a question of how one should treat payments under hire-purchase agreements or under leasing arrangements, which at least in part have the same character as interest. It might be possible to draw a distinction between short-term and long-term loan capital and to deny a deduction of interest on the latter, but the line of ratio would necessarily be arbitrary. The Committee considers that in general the present method of taxing loan capital should be retained. However, there are two situations—one relating to convertible notes, the other to the high gearing of loan to share capital—where it may not be inappropriate, for tax purposes, to treat loan capital like share capital.
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16.147. Convertible notes. The present tax treats certain loan capital, generally referred to as convertible notes, in the same manner as share capital. In 1960 interest on notes carrying an option of conversion into shares was made non-deductible in determining the taxable income of the company. In 1970 deductibility of interest on some convertible notes was restored. Deduction is allowed only if the convertible notes meet strictly defined statutory tests intended to ensure that they serve the commercial purposes for which they are ostensibly issued. Thus the option to convert must rest with the note-holder so that, pending conversion, he has the income yield and security of investment that the note provides.
16.148. If deduction were allowed of interest paid on all convertible notes, the operation of the system of taxing company profits would be undermined. That system, where no undistributed profits tax applies, depends for its operation on pressure by those who have an interest in accumulated profits for some measure of current distribution. In the case of a high-income shareholder, the under-taxation of undistributed profits is compensated for by the over-taxation, at company and shareholder levels, of distributed profits. In the case of a holder of convertible notes, whose security gives him a potential claim on a portion of undistributed profits, the pressure for current distribution is satisfied by the interest he receives. This interest will not, however, have borne tax at the company level if the convertible notes are treated as loan capital. The Committee therefore considers that the general denial of deduction of interest on convertible notes should remain.
16.149. Where, however, there are safeguards against defeat of the general operation of the system of taxing company profits, the deduction may be appropriate. The Committee thus does not question the statutory code under which interest on convertible notes is deductible in defined circumstances. Those circumstances are defined so as to ensure that the commercial purposes of the convertible note issue predominate over any tax advantages which may flow.
16.150. High gearing. Where interest is paid by a resident company to a resident, the Committee does not consider that a high gearing of loan to share capital should affect deductibility. The fact that the gearing of loan to share capital may be too high, as a matter of commercial judgment, is a concern of the tax law only so far as it points to the need to overcome the want of neutrality in the treatment of share and loan capital which may have encouraged the high gearing. It does not justify, in the case of a particular company, the denial of deduction of interest on some part of the loan capital.
16.151. However, the Committee would take a rather different view in regard to some loan capital held by a non-resident
in an Australian resident company. The taxation of non-residents is considered in Chapter 17. For present purposes it
is enough to refer to the fact that Australian tax on profits distributed as dividends to non-residents amounts to
company tax, currently 45 per cent, plus a 30 per cent dividend withholding tax (15 per cent if a double taxation
agreement limits the rate of tax); on the other hand, Australian tax on profits going in payment of interest to a
non-resident is confined to a withholding tax of 10 per cent of the amount of interest so paid. Thus the tax on $100
of profits distributed as dividends (assuming a 30 per cent withholding tax rate) is $63.33; the tax on $100 of
profits distributed as interest is only $10. While the Committee does not wish to pronounce generally on the
appropriateness of the rate of withholding tax on interest, it is apparent that the low rate may lead a foreign
resident investor who controls an Australian resident company to provide an undue proportion of the capital of the
company in the form of loan finance. The
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inducement to do so will depend on the level of tax in the
country of the investor's residence and the credit for foreign tax that country may allow. The inducement will be at
its greatest when the foreign investor is resident in a low-tax, sometimes called a tax-haven, country. Canada has
recently adopted provisions which may deny a deduction of a portion of interest payable to a non-resident by a
resident company where, either alone or in combination with others, the non-resident owns more than 25 per cent of the
shares of the company. The denial depends on the ratio of the loan capital held by the non-resident to the share
capital of the company. In the Committee's view, provisions along the lines of the Canadian model should be adopted in
Australia. It is realised, of course, that such provisions will operate subject to any double taxation agreement to
which Australia is, or may become, a party.
16.152. Alternatively to contributing an undue proportion of capital by way of loan finance, subject to the provisions of the exchange control law a non-resident may lend a smaller amount at a high rate of interest, calculated to have the same effect. Provisions intended to enable what would amount to treating the loan capital on which the interest is paid as share capital are proposed in the next chapter.