Chapter 2
The provisions of Schedule 2 of the bill
History of Division 247
2.1
Division 247 of the ITAA 1997 is a relatively new addition to the income
tax acts. The division specifically requires that, for income tax purposes, the
part of the expense attributable to the cost of capital protection on a capital
protected borrowing be treated separately from the amount attributable to
interest payable on a borrowing without capital protection, and that the
expense attributable to the cost of capital protection not be deductible where
that cost was capital in nature.[1]
It does this by splitting CPBs into two artificial components: (1) an
underlying loan; and (2) a put option (capital protection).[2]
This is a synthetic exercise conducted for tax purposes as
the ‘put option’ is not tradable by the investor in the way that normal put
options are and it does not have a life independent of the ‘underlying loan’,
which itself does not exist in the absence of the put option.[3]
2.2
The apportionment methods of Division 247 use a benchmark interest rate,
the RBA's indicator lending rate for personal unsecured loans – variable rate,
to calculate the apportionment of the interest expense.[4]
It is this indicator lending rate that will be amended by Schedule 2 of Tax
Laws Amendment (Measures No. 5) Bill 2010.
The proposed amendment
2.3
Schedule 2 of the bill will amend Division 247 of the Income Tax
Amendment Act 1997 and Division 247 of the Income Tax (Transitional
Provisions) Act 1997 to adjust the benchmark interest rate used to
determine the cost of capital protection on a CPB from the Reserve Bank of
Australia's indicator lending rate for personal unsecured loans to the RBA's
indicator lending rate for standard variable housing loans plus 100 basis
points.[5]
2.4
The proposed change is retrospective in operation and will apply to CPBs
entered into or extended after 13 May 2008.[6] The retrospective date of application
relates to the date that the government first announced they intended to amend
the benchmark interest rate; on 13 May 2008 in the 2008-09 federal budget.
2.5
In that budget the government detailed that the benchmark interest rate
used to determine how much of the interest expense incurred by a borrower under
a CPB may qualify for a deduction under the general deductibility rules for
income tax would be changed from the indicator lending rate for personal
unsecured loans to the standard variable housing loan rate.[7]
Although that change did not proceed and differs from the benchmark rate
proposed in Schedule 2 of the bill currently before the parliament, the
proposed amendment is still to be backdated.
2.6
The benchmark interest rate to be used for Division 247 purposes,
following passage of Schedule 2 of the bill, will be the indicator lending rate
for the standard variable housing loan rate plus 100 basis points. The
'uplift' of 100 basis points[8]
is explained in the Explanatory Memorandum:
The addition of 100 basis points is to reflect the typically
relatively small additional credit risk of the issuer for the cost of capital
protection that is paid on a deferred basis.[9]
Views on the bill
What is an appropriate benchmark
interest rate?
2.7
Submitters to the committee are critical of the proposed benchmark interest
rate change. They contend that the proposed rate does not align with the purpose
and object of the Division as intended when introduced:
When the Division 247 provisions were enacted in 2006, the
personal unsecured loan rate as the benchmark interest rate was adopted as a
specific design feature of the law. In other words, the level of the benchmark
rate interacted with the other provisions in Division 247 to produce the
desired policy outcome.[10]
...to deny a deduction for that portion of the limited
recourse borrower's costs that approximate the alternative explicit capital
protection cost, such that the limited recourse borrower is not treated
advantageously...the purpose of the provision is to deny a deduction for the
amount that is comparable to the cost of acquiring separate and explicit [capital]
protection.[11]
2.8
The Tax Institute of Australia (TIA) takes the view that the proposed
change reverses the original purpose such that the rate will no longer result
in an apportionment calculation reflective of the cost of separately acquiring
capital protection. They are also concerned that the proposed change will
distort both funding and protection choices of investors as well as investment
choices.[12]
2.9
The Australian Financial Markets Association (the peak body representing
participants in the Australian wholesale banking and financial services
markets) raised similar concerns to those of the TIA. AFMA suggest that the
proposed rate is fundamentally flawed and does not achieve a better allocation
of the cost of capital protection for borrowers.[13]
2.10
Industry participants acknowledge the challenges policy makers face in determining
the appropriate benchmark rate:
The challenge with setting a benchmark is that it is, by
definition, going to be somewhat ad hoc. Each and every instrument that is
issued, and the nature of a capital protected product, will have its own
specific level of protection. In a pure theoretical sense you could have a
separate rate for each and every product that is issued. In a practical sense
that would create enormous compliance costs for both the tax office and
taxpayers. I think it would lead to a lot of dispute in individual cases around
about where the right level of protection is.[14]
2.11
Yet these industry stakeholders suggest that the assumption that the
home loan and CPB markets are similar is incorrect and therefore take the view
that the proposed rate is inappropriate:
The policy proposal in TLAB 5 assumes a close similarity
between a home loan and a capital protected borrowing that does not exist. They
are very different markets in terms of scale, service provision, credit risk
and business costs.[15]
2.12
Industry participants identify these factors (risk involved, market
scale, and administration costs) as those that should be taken into account when
determining the appropriate benchmark interest rate.[16]
2.13
AFMA reject Treasury's view that CPBs are risk free loans as although
the 'put option' component provides protection to the issuer, risk is not
completely neutralised as CPBs generally have maturities greater than 12 months
yet the cost of the capital protection feature is often only paid for one year
in advance; capitalised; or paid monthly in arrears.[17]
In addition, in contrast with housing loans that generally involve monthly
repayments of both principal and interest, CPBs are interest only loans:
Thus, the average line of credit outstanding is greater for a
capital protected loan than it is for a home loan for the same initial loan
amount and loan term. This is relevant in the context of break fees and
interest forgone in the event of default, as the protection feature only
ameliorates credit risk in respect of the principle lent at maturity of the
loan and it does not eliminate the asset risk of default to the issuer/lender.[18]
2.14
AFMA also contend that the different purposes of home loans and CPBs
result in very different administration costs, not only as a result of the much
smaller scale of the CPB market,[19]
but also given its less homogenous nature.[20]
2.15
Following the strong claims made by AFMA and the TIA, the committee
questioned Treasury officials. In response to questioning concerning the
rationale for setting an appropriate benchmark interest rate, the Treasury
officials explained:
Mr Paul—The setting of the benchmark rate is seeking
to get the right balance between not stimulating the use of this particular
product by overgenerous tax treatment and, at the same time, not inhibiting the
use of this product by the tax treatment. Another way to put that is achieving
a neutral tax result...If the effect of the measure is to reduce the use of a
product for tax purposes then that would be a good thing. The determination of
the benchmark rate in the advice that we have given, in any event, was not
trying to inhibit the use of the product...
CHAIR—You are saying that you are looking for a
relatively neutral outcome. So the use of these instruments is not to
deliberately as part of a package avoid tax; it is just a measure to get some
administrative ease into the system.
Mr Paul—No, it is not solely for administrative
purposes. If the rate is too generous, if too much of the interest component is
put into the interest on the loan as opposed to the cost of capital detection,
that will provide an incentive for the product to be used to reduce tax. The
analysis of the benchmark rate has been on the basis that it should not be so
high as to provide an incentive to reduce tax. It should be based on its
merits.[21]
2.16
Treasury went on to explain that a financial consultant had been engaged
to provide advice in the development of the measure. They detailed that the
consultant initially advised that the secured housing loan rate was comparable
to the interest costs of a CPB as they have similar credit risks and loan
administration costs whereas use of the personal unsecured loan rate
overestimates the rate that should be used[22]
and that the government's decision to set the benchmark interest rate at the
indicator lending rate for the standard variable housing loan rate plus 100
basis points was that it be set:
...halfway between the consultant's original advice of the
standard housing loan rate and what the consultant said was the upper bound,
which was the margin loan rate.[23]
2.17
The Committee sought to explore this formula for determining the
appropriate rate further:
CHAIR—...Why wouldn't it be set at the margin loan
rate? Why wouldn't you set it at that?
Mr Paul—At the end of the day, that is a matter of
some judgment. The closer you get, the granularity between one rate and
another, there is going to be some judgment about what sort of impact that will
have. It is not for me to say where that judgment lay in terms of government
decision.
CHAIR—So you are saying that there were various
options put to government?
Mr Paul—...The decision was half way between. Where in
that scheme of things, how much difference that would make, is really a matter
of judgment.[24]
2.18
Treasury explained that both margin loans and CPBs are relatively low
risk products which are more closely aligned to each other than to the personal
unsecured loan rate[25]
and although they were initially advised that use of the margin loan rate would
result in an overestimation of the capital protection cost involved in a CPB,
following industry feedback they advised that the standard housing loan rate
was still the best estimate but that the margin loan rate would be the upper
bound.[26]
2.19
Chart 1 shows three bank interest rates published by the Reserve Bank of
Australia. The top line refers to personal unsecured variable rate loans, the
rate currently applied by the legislation. The bottom line refers to variable
rate housing loans, which was proposed by the original version of the current
bill. The middle line is the interest rate on margin loans. The current
proposal in the bill is for the housing loan rate plus 1 per cent (100 basis points),
which would bring it close to the margin loan rate.
Chart 1: Banks' average interest rates on types of loans
Source: Secretariat, based on
data from Reserve Bank of Australia.
Claimed consequences
Contraction of the CPB market
2.20
In their evidence to the committee, AFMA suggested that the reduction in
the benchmark interest rate from the personal loan rate to the standard
variable housing loan rate plus 100 basis points would have unintentional
consequence, most notably, they pointed to the change as the reason for a
steady decline in the use of CPBs as an investment tool.[27]
...around the time the budget announcement was made in 2008
it also became a very difficult time during the global financial crisis. That
had an impact on the risk appetite that people had. What we saw with protected
equity loans was that they continued to grow during the early parts of the
crisis but, once the budget announcement was made, they fell off fairly
sharply. That led us to the conclusion that certainly there were economic
factors at work as well in terms of the market trends. The tax issue was quite
significant...The markets have long since stabilised but this market has not
recovered which suggests that there is more than just the GFC issue at play.
2.21
The Australian Securities Exchange echoed AFMA's concerns.[28]
2.22
When these issues were raised with Treasury officials, they advised that
no specific modelling on behavioural changes had been undertaken and that such
modelling may not be reliable:
It can be quite difficult to separate some of the tax issues
from the non-tax issues in something like this. It has been mentioned that
there was a fall in the uptake of the capital protected borrowing arrangements
in about 2008. At the same time, our information is there was a fall-off in the
take-up of other types of products–things like margin loans. There was an
article in the Financial Review in June 2008 which pointed out that
there was a drop in what they referred to as tax-cutting strategies...That
article pointed to the credit crisis and share market slump as being
contributing factors to the fall‑off in those products. How much you can
attribute that to the government announcement of a tax change and how much to
conditions in financial markets is a difficult question.[29]
2.23
Treasury said that in setting the benchmark rate they were not trying to
inhibit use of the product.[30]
2.24
AFMA remains convinced that the proposed amendment will result in
behavioural changes as it extends the scope of Division 247 to many more financial
products than currently captured:
During consultations in the lead up to Tax Laws Amendment
(2006 Measures No. 7) Bill 2006, AFMA was advised that it is not the policy
intention to capture project finance and other business finance transactions
under Division 247 [as]...these transactions do not pose a risk to tax revenue
in this context and also because there would be a cost to economic performance
if tax deductions for interest payments on business investment were limited in
this manner.
Nonetheless the law was not written to limit its application
to retail investors only...to avoid the technical challenge of distinguishing
between retail investors and business for the purpose of this part of the law.
This apparent inconsistency was resolved by excluding a wide range of common
loan products because their interest rates fell comfortably below the unsecured
personal loan rate...However, the extraordinarily broad definition of a capital
protected borrowing in s.247-10 does capture common business loan arrangements.[31]
2.25
They identify examples of the situations in which these unintended
consequences will be burdensome for taxpayers:
For example, consider a small business that holds financial
assets on its balance sheet as part of a strategy to manage its liquidity and
investment needs, including a small share portfolio which is partly capital protected.
If this business enters a full recourse loan with a bank to acquire new equipment,
then Division 247 will deem there to be a capital protected borrowing... Since
the small business loan rate is 9.70% compared to the standard variable home
loan rate of 7.8%, the business would be denied almost 10% of their interest
expense as a tax deduction. Interest would be deductible in full if either the
margin loan rate or the unsecured personal borrowing rate were used as the
benchmark interest rate.[32]
A lot of warrant issues have a small element of capital
protection to them, and therefore the unsecured person loan rate, for example,
would give full deductibility in relation to those investments... [As a result
of the change, although instalment warrants] are a much lower risk from the tax
revenue point of view in the sense that the amount that may be non-deductible
in some cases is quite low...they would then have to file a tax return which
splits the interest rate into two components.[33]
2.26
The concern that the operation of the Division will widen if the
proposed amendments proceed was also put to Treasury, who identified this was a
subject for further consultation:
Senator BUSHBY—Has there been any assessment of the
issue raised by AFMA regarding catching business arrangements that were not
originally intended and any plans to address that?
Mr Paul—As I mentioned with the consultation summary,
the government’s position is that those issues other than the benchmark rate
are things that would be subject to consultation between Treasury on the one
hand and industry and the ATO on the other.[34]
Negative implications for revenue
projections
2.27
If the CPB market continues to deteriorate, as has been suggested by
industry, it is possible that the revenue projections released at the time of
the measure's announcement will also be affected as a reduction in the use of
CPBs is likely to cause a consequential reduction in revenue collections:
When we looked at revenue we considered a number of factors.
That included direct impact...our assessment was...that the market would fall
back substantially. It has done that. Further, the level of activity in the
income generator within that part of the industry has declined commensurately.
Also the number of people employed in that part of the industry has been
reduced. For a variety of reasons we think revenue certainly will not meet the
expectations that are in the forecast.[35]
Future CGT receipts are significantly reduced by the lower
benchmark for two reasons:
- CGT liability as sale of the
underlying share is reduced by the higher cost of the notional put option under
the new benchmark rate; and
- less use of the product means less
capital gains will be earned and less CGT is paid.[36]
2.28
When questioned about the potential for revenue to be negatively
affected however, Treasury explained that their estimates had factored in a
drop in the take-up rate of capital protected instruments:
...but against that was an increase in the forecast spread
between the standard variable housing loan rate and the personal unsecured
rate, which has the effect of increasing the gain to revenue. [37]
2.29
They did note however that modelling methods between the time of the 2008-09
budget measure and the 2010 measure had changed which had led to some
conflicting tendencies.[38]
Committee comment
2.30
Industry acknowledge that establishing a reasonable benchmark interest
rate is a difficult technical issue that is somewhat arbitrary but make a valid
point:
Where we are now is really a question of trying to determine
a benchmark that will enable the market to operate effectively and enable
investors who want to seek capital protection to do so without unduly being
penalised... In terms of providing choice to investors who make decisions about
managing their investment risks and exposures in a particular way, we think
this is important in that sense.[39]
2.31
The committee agrees that there is a need to provide investors with
choice and notes that the benchmark rate proposed by Schedule 2 of the bill has
been determined somewhat arbitrarily (being chosen as the midpoint between the
lower and upper bounds advised by an external consultant.) The committee
recognises that the government has responded to industry criticism of the
proposal to set the rate at the variable housing loan rate. The committee also
notes that for a significant period, highlighted in Chart 1, the proposed rate
(variable rate plus 100 basis points) would be close to the margin loan rate.
It is also possible that the trend will be for these rates to once again follow
this trajectory.
2.32
In light of industry feedback and Treasury's acknowledgment that the
risk associated with CPBs is similar to that involved in margin loans, the rate
proposed in Schedule 2 should be amended such that the benchmark interest rate
can be varied within the appropriate range of the variable housing loan rate
and the margin loan rate.
2.33
The committee considers that this would strike the balance needed to enable
the industry to continue to develop responsibly whilst protecting the revenue
by reducing the interest rate currently used to determine deductibility and which
is not reflective of the risk involved in the CPB market.
Recommendation 1
2.34
The committee recommends that the benchmark interest rate to be used for
Division 247 purposes, as set out in Schedule 2 of the bill, be amended to reflect
a range between the variable rate for housing loans and the Reserve Bank of
Australia's indicator lending rate for margin loans. The actual figure would be
determined by the Treasurer to reflect market trends.
Recommendation 2
2.35
The committee recommends that the Senate pass the bill (if there are no
objections to the other schedules not examined by the committee).
Senator Annette Hurley
Chair
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