THE BANK'S PURPOSE
94 It is possible to arrive at the relevant conclusion as to purpose by making a global assessment of the facts, so long as it is clear that all of the relevant matters referred to in s 177EA(17) are taken into account. There may be overlap among the various matters. Some of them may point one way. Others may point in the opposite direction. Some may be neutral. Section 177EA(3)(e) requires an evaluation of all of the matters, alone or in combination, some for and some against, in order to reach the appropriate conclusion. Further, there is no inconsistency between a finding that the purpose of a person lay in the pursuit of some commercial benefit in the course of carrying out a business, and a finding that a non-incidental purpose was to enable a relevant taxpayer to obtain an imputation benefit (see, for example, Commissioner of Taxation v Sleight (2004) 136 FCR 211 at [67]).
95 The Taxpayer complains that the reasoning of the Commissioner in making his determination under s 177EA(5)(b) involved the examination of the individual paragraphs of s 177EA(17) on a strictly literal reading, without regard either to the context or purpose of those paragraphs or the object of s 177EA as a whole. While it is necessary, ultimately, to make an evaluation of all of the relevant matters, both alone and in combination, in order to reach a conclusion such as is called for by s 177EA(3)(e), it is necessary to deal with each of the matters separately in the first instance.
96 The first matter to be considered, under s 177EA(17)(a), is the extent and duration of the risks of loss and the opportunities of profit or gain, from holding the Relevant Securities, that are respectively borne by or accrue to the Bank and the Taxpayer. It is also necessary to have regard to whether there has been any change in those risks and opportunities for the Taxpayer or the Bank.
97 The Commissioner contends that those matters focus attention on the nature of the Taxpayer's ownership of the Relevant Securities, on which the frankable distribution of 1 February 2010 was paid. He says that the provision draws attention primarily to whether the Taxpayer is really the holder of the Relevant Securities on which the frankable distribution is paid and whether, and the extent to which, some other party has really borne the risks of ownership of the Relevant Securities. The Commissioner accepts that this matter is most applicable to trading schemes of the kind referred to in the explanatory memorandum. However, he says, the provision also permits consideration of the extent to which the holder of Relevant Securities is exposed to the risks of being a shareholder. That is, he says, it may to some extent require consideration of the extent to which the Relevant Securities are like equity.
98 The Taxpayer disputes that contention. However, against the possibility that there was some substance in the contention, the Taxpayer adduced evidence from Professor John Handley, who is an Associate Professor of Finance at the University of Melbourne. Professor Handley holds the degrees of Bachelor of Commerce and Bachelor of Mathematics from the University of Newcastle and the degrees of Master of Commerce and Doctor of Philosophy from the University of Melbourne. Professor Handley was asked to set out his views on the extent and duration of the risks of loss and the opportunities for profit or gain on an investment in Relevant Securities.
99 Professor Handley first outlined the factors that contribute to the risk of loss and opportunity for gain in relation to periodic Distributions on the Relevant Securities prior to an Exchange Event. Those factors include the following:
The Distributions are discretionary and are subject to certain payment tests and, therefore, there is a possibility that they may not be paid.
The Distributions are non-cumulative and, accordingly, the holder has no right to demand payment of any Distribution that has not been paid.
The Distributions rank ahead of dividends on Ordinary Shares but are subordinated to certain other distributions.
The Distribution Rate is based on a benchmark interest rate, which is floating. Accordingly, if that benchmark rate increases the Distribution will increase, but if the benchmark rate decreases the Distribution will decrease.
The Distribution Rate is dependent upon the Australian current corporate tax rate. If the corporate tax rate increases, the cash amount of the Distribution will decrease and if the corporate tax rate decreases, the cash amount of the Distribution will increase.
100 Professor Handley considers that those factors suggest that there is a substantial risk of loss, primarily from non-payment, with some opportunities for gain, primarily from possible increases in the benchmark rate in relation to the periodic Distributions. He considers, however, that, as a practical matter, the risk of loss is mitigated, but not eliminated, by the facts that:
The Bank has a strong profit and dividend history.
Although the payment of a Distribution is discretionary, non-payment will restrict the Bank from making distributions or returning capital on Ordinary Shares and other junior ranked securities.
Although Distributions are non-cumulative, the Bank has the option to make up any unpaid Distribution in the form of an optional dividend.
Although the cash amount of the Distribution is based on the corporate tax rate applicable to the relevant distribution period, changes in the corporate tax rate have no effect on the equivalent unfranked amount of the Distribution, assuming the potential value of the franking credit is taken into account in full.
101 Professor Handley also identified the factors that contribute to the risk of loss and opportunity for gain in relation to return on the Relevant Securities in the event of an Exchange Event. Those factors include the following:
The Relevant Securities rank, in effect, as a preference share in the event of a winding-up, ahead of Ordinary Shares, but behind creditors.
If Exchange occurs by Resale or Repurchase, the holder receives a fixed cash amount.
If Exchange occurs by Conversion, the holder receives a variable number of Ordinary Shares, a transaction designed to provide the holder with the same dollar value of Ordinary Shares at Conversion, being approximately $202.02, irrespective of the price of Ordinary Shares at that time.
Exchange by Resale requires the Bank to arrange a third party purchaser to buy the Relevant Securities at face value, but that may not be possible at the time.
Exchange by Repurchase requires the Bank to buy back the Relevant Securities at face value, subject to the approval of APRA. That is dependent on the refinancing capacity of the Bank at the time.
Exchange by Conversion provides the holder with Ordinary Shares rather than cash. A holder who wishes to cash out the investment would then need to sell the shares on the market and so would be exposed to movements in the price of Ordinary Shares between the date of Conversion and the date of sale.
The second Conversion condition eliminates the exposure that a holder would otherwise have to an Ordinary Share price below a certain level.
The Bank chooses the method of Exchange, whether Resale, Conversion or Repurchase.
102 Professor Handley considers that those factors suggest that there is some risk of loss and some opportunity for gain, primarily from possible differences in the value of shares received on Conversion, in relation to return on Exchange. However, the holder will receive a return of $202.02 in shares on Conversion only if the volume weighted average price, which is used in determining the number of shares on Conversion, is equal to the share price at the time. The holder is therefore exposed to movements in the price of Ordinary Shares over the 21 business days up to and including the date of Conversion. Further, a holder who wishes to cash out would have an additional exposure to movements in the price of Ordinary Shares between the date of Conversion and the date when the Ordinary Shares are sold.
103 The holder of Relevant Securities could also dispose of the holder's investment in them prior to an Exchange Event, by selling them on the market. Depending upon the sale price, the holder may make either a capital gain or a capital loss. The highest and lowest closing prices of Relevant Securities from 14 October 2009 to 21 May 2010 were $210.50 and $203.05 respectively.
104 However, Exchange by way of Conversion is not certain, as the Bank has other alternatives available, namely Resale or Repurchase. Accordingly, a holder's exposure to movements in the price of Ordinary Shares around the time of Conversion is but one factor contributing to the risk of loss and opportunity for gain at the time of Exchange. After examining market information concerning the price of Ordinary Shares in the Bank, Professor Handley concluded that, while the holders of Relevant Securities are likely to receive approximately $202.02 on Conversion, there is an exposure to movements in the price of Ordinary Shares in the Bank around the date of Conversion, and in some cases that could lead to a material gain or loss on Conversion.
105 Professor Handley considered that the holders of Relevant Securities are exposed to the same risks of loss and opportunities for gain on the investment, regardless of whether it is in the form of a stapled security, prior to an Assignment Event, or a Preference Share, after an Assignment Event. His reason for that conclusion is that the return is the same, whether it is a distribution in respect of the Note or a dividend in respect of a Preference Share. If Exchange occurs, the holder receives the same fixed cash amount, regardless of whether an Assignment Event has occurred. Similarly, if Exchange occurs by Conversion, the holder receives the same number of Ordinary Shares, regardless of whether an Assignment Event has occurred.
106 Professor Handley concludes that the Relevant Securities have features that expose investors to equity-like risks in that, like ordinary shares, payment of the periodic Distribution is subject to the discretion of the Bank and to payment tests, including availability of profits in the current period. As with ordinary shares, the holders generally rank behind other creditors of the Bank in a winding up, although they rank as a preference share and therefore ahead of the holders of ordinary shares. At the same time, the Relevant Securities have some debt-like features, although those features are qualified by the equity-like aspects. Like senior debt, the periodic distribution is based on an external benchmark interest rate, but the significantly higher margin indicates that the market was of the view that the risk of an investment in the Relevant Securities was greater than the risk of an investment in senior debt of the Bank at the time of issue. Further, like senior debt, the holders of Relevant Securities expect to have their capital repaid at maturity. However, unlike senior debt, repayment may be in the form of a parcel of Ordinary Shares rather than cash. That exposes investors to movements in the price of Ordinary Shares in the Bank around the time of Conversion and beyond, if the holder continues to hold the Ordinary Shares.
107 The opinions of Professor Handley are unremarkable. His conclusions are derived from the nature of the rights attached to the Relevant Securities. Ultimately, Professor Handley is more or less equivocal as to the extent to which the holder of Relevant Securities is exposed to the risk of loss and has opportunity for profit or gain.
108 In any event, the language of s 177EA(17)(a) calls for consideration of the risk of loss or the opportunity for profit from holding Relevant Securities that are borne by or accrue to parties to the scheme, and whether there is any change in those risks and opportunities. I do not consider that this analysis of risk and opportunity in relation to the holding of the Relevant Securities is a relevant matter under s 177EA(17)(a). There is no suggestion that the Taxpayer entered into an arrangement that modified his exposure to the risk of loss or the opportunity for gain arising from the holding of the Relevant Securities. Nor is there any suggestion that the Taxpayer entered into any arrangement that transferred the exposure to risk or the opportunity for gain to a third party. The terms of the Relevant Securities and the rights arising from holding them are stated in the Note Terms and the Preference Share Terms forming part of the Prospectus. While the rights of holders change from time to time, in the circumstances described above, the risk of loss and the opportunity for gain are determined at the time when the Relevant Securities are issued. While the Relevant Securities have some equity-like aspects, the distribution rights are very similar to rights to receipt of interest. However, those rights remain static from the time of issue. I do not consider that the relevant matter points towards a purpose of enabling the holder to obtain an imputation benefit. Nor does it point away from such a purpose.
109 The second matter, under s 177EA(17)(b), is whether the Taxpayer would, in the year of income in which the relevant distribution was made, namely the year ending 30 June 2010, derive a greater benefit from franking credits than would other entities who hold membership interests in the Bank. Section 177EA(19) lists some of the cases in which a taxpayer to whom a distribution flows indirectly receives a greater benefit from franking credits than other entities who hold membership interests. Those circumstances include, but are not limited to, the following:
The entity is not an Australian resident.
The entity would not be entitled to any tax offset under Division 207 of the 1997 Act because of the distribution.
The amount of income tax that would be payable by the entity because of the distribution is less than the tax offset to which the entity would be entitled.
The entity is a corporate tax entity but no franking credit arises for the entity as a result of the distribution.
The entity is a corporate tax entity but cannot use franking credits received on the distribution to frank distributions to its own members.
110 In the explanatory memorandum, the matters referred to in s 177EA(17)(b) are described as the tax profiles of the parties to the scheme. The Commissioner contends that that description highlights the matters with which s 177EA(17)(b) is concerned, namely the extent to which a taxpayer who enters into a scheme is more able than other shareholders to enjoy franking credits. Only certain investors will be in a position to utilise franking credits fully. Accordingly, a scheme primarily directed at, or primarily taken up by, such investors may point to the existence of the relevant purpose.
111 The Taxpayer points out that the Relevant Securities are available for ownership by any person who can be an owner of Ordinary Shares. There is no impediment to an acquisition of Relevant Securities by non-resident investors after they have been issued. While the proportion of holders of Relevant Securities who are non-resident is low, so is the proportion of holders of Ordinary Shares who are non-resident. The Taxpayer says that those circumstances indicate an absence from the arrangement for issue of the Relevant Securities of any purpose, collateral or otherwise, of enabling any taxpayer to obtain an imputation benefit.
112 It is possible that, because of matters relating to the regulation of public offerings, and the cost of satisfying regulatory bodies in other jurisdictions, the Relevant Securities were not offered to investors other than Australian residents. However, there was no evidence as to why the Relevant Securities were not offered to prospective investors outside Australia. Further, unless the holder can make use of the franking credit, the Relevant Securities are not of as great a value. They are of greater value to an Australian resident, who can take advantage of the franking credit. The fact that holders of Ordinary Shares in the Bank are also mostly Australian residents is equivocal in circumstances where all distributions on Ordinary Shares in the Bank have been fully franked. I consider that the matter described in s 177EA(17)(b) points to the relevant purpose.
113 The third matter, under s 177EA(17)(c), is whether, apart from the scheme, the Bank would have retained the franking credits or would have used the franking credits to pay a franked distribution to another entity holding membership interests in the Bank. The Taxpayer contends that, if the Bank had not issued the Relevant Securities, it would most likely have satisfied its need for Tier 1 capital by an issue of perpetual non-cumulative preference shares. Such securities, from an investor's viewpoint, would have had the same characteristics and attraction. Distributions on such a capital raising would have been franked in the same way and to the same extent as the Relevant Securities.
114 However, even if that were a likely alternative to the Relevant Securities, s 177EA(17)(c) requires a judgment about purpose, having regard to all the relevant circumstances, most of which do not depend upon an alternative circumstance. The Bank implemented a scheme whereby investors obtained an imputation benefit. Their return was calculated by reference to that benefit. The payment was nevertheless deductible to the Bank against its New Zealand income. While the fact that the Bank could otherwise have used the franking credits in a different transaction may be relevant, it is far from determinative. I do not consider that the matter in s 177EA(17)(c) points towards or away from the relevant purpose.
115 The fourth matter, under s 177EA(17)(d), is whether, apart from the scheme, a franked distribution would have flowed indirectly to another entity who holds membership interest in the Bank. That consideration is relevant to the streaming or deflection of franking credits away from shareholders to whom they are of little value. As with s 177EA(17)(c) the circumstance does not point towards the relevant purpose.
116 Section 177EA(17)(e) only applies where the relevant scheme involves the issue of a non-share equity interest to which s 215-10 of the 1997 Act applies. Section 215-10 does not apply. The fifth matter, therefore, has no relevance in the present case.
117 The sixth matter, under s 177EA(17)(f), is whether any consideration paid or given by or on behalf of, or received by or on behalf of, the Taxpayer, in connection with the scheme (for example, the amount of any interest on a loan), was calculated by reference to the imputation benefits to be received by the Taxpayer. The Taxpayer contends that this circumstance is directed to franking credit trading of which there is no element in connection with the issue of the Relevant Securities. Distributions on the Relevant Securities are calculated on an after tax basis. That is to say, the amount distributable is increased if the Distributions are not franked. He says that that is a normal incident of an investment in a security treated for tax purposes as a preference share, by which the investor is assured of the promised preferential rate of return on the securities. That puts the securities in the same position as was formerly occupied by preference shares, the dividends upon which carried an entitlement to a rebate of tax under s 46 of the 1936 Act. He points out that there is no return to the Bank of the value of the imputation credits.
118 However, the return to the holder of the Relevant Securities is calculated by reference to franking credits. The Bank has an obligation to compensate the holder to the extent that franking credits are unavailable, thus ensuring that the total return to the holder of Relevant Securities is always equal to the sum of the Distribution paid together with the financial benefit of the attached franking credit. Thus, the imputation benefit is integral to the return on the Note. The imputation benefit is the very thing that makes an investment in the Relevant Securities commercially acceptable. I consider that this circumstance points towards the relevant purpose, which was not merely incidental.
119 The seventh matter, under s 177EA(17)(g), is whether a deduction is allowable, or a capital loss is incurred, in connection with a distribution that is made or that flows indirectly under the scheme. The Commissioner accepts that there is no deduction available against Australian tax for Distributions made by the New Zealand branch of the Bank. The provision is not concerned with whether a deduction is allowable for, or a capital loss is incurred by, the distribution itself, but with whether the assessable income derived on receipt of the distribution is offset by a loss deductible or allowable to the recipient of the dividend. That is the position with schemes by way of dividend stripping or franking credit trading. There is no such scheme in the present case. This matter therefore tends to point away from the relevant purpose.
120 The eighth matter, described in s 177EA(17)(ga), is whether a distribution that is made under the scheme to the Taxpayer is sourced, directly or indirectly, from unrealised or untaxed profits. The Commissioner relies heavily upon this provision, the construction of which is subject to dispute between the parties.
121 The provision was inserted by Act No 79 of 2007, which also repealed the dividend tainting rules of the 1936 Act, by which dividend rebates were denied in respect of dividends out of untaxed profits. The amendment was part of the replacement of dividend rebates under s 46 by the application of the imputation system to corporate dividends. The Taxpayer contends that the mischief to which both the repealed provisions and this provision were directed is the making of franked distributions out of unrealised or untaxed profits or from shared capital accounts, including tainted capital accounts, as a means of liberating franking credits that would otherwise be trapped in the company because of the absence of distributable profits.
122 The Taxpayer contends that the distributions of the Relevant Securities are not made from unrealised or untaxed profits. Rather, he says, they are paid from the income of the Bank as an expense of deriving profits from which dividends are paid. It is only for the purposes of the 1997 Act, and by virtue of the deeming provisions of the 1997 Act, that the Relevant Securities are treated as equity interests and the interest on the Notes as a non-share dividend. He says that, if it were appropriate to impute the effect of the deeming to the identification of the fund from which the payments are made, the distributions are paid from the taxed trading profits of the Bank. He says that the fact that the Relevant Securities are issued from the New Zealand branch of the Bank does not make them a deposit liability of the New Zealand branch. The liability to pay distributions is not limited to the New Zealand assets of the Bank. Therefore, he says, the distributions are not sourced in New Zealand profits and would not be so sourced, even if they were secured on the New Zealand assets of the Bank, which they are not. He says that the issue of and Distributions on the Relevant Securities are not within the mischief to which s 177EA(17)(ga) is directed.
123 The Commissioner says, on the other hand, that it is wrong to assume that the provision is concerned solely with circumstances that would previously have been addressed by the dividend tainting rules. Rather, he says, the fact that the provision was inserted into s 177EA(17) indicates that that it was intended to be part of the general anti-avoidance scheme contained in s 177EA.
124 The distribution in question is, at least in legal form, a payment of interest on a promissory note. As such, it is not a distribution of, or a payment that is sourced from, profits of the Bank, in the sense in which that expression is used in the context of company law. The reference to profits in the provision must be construed in the context of the provision as a whole, namely as an anti-avoidance provision that applies equally to schemes involving a dividend on shares as well as to schemes in which the distribution is in respect of a non-share dividend, and thus not necessarily involving a distribution of profits in the company law sense. Thus, s 177EA applies, according to s 177EA(12), to a non-share equity interest in the same way as it applies to a membership interest, to an equity holder in the same way as it applies to a member, and to a non-share dividend in the same way as it applies to a distribution.
125 The distribution in question was paid by the New Zealand branch of the Bank, the income of which is exempt from tax in Australia under s 23AH of the 1936 Act. It is accepted by the Taxpayer that the funds used by the Bank's New Zealand branch to pay the distribution on the Notes were earned by the Bank's New Zealand branch. Further, the distributions were not sourced from the Bank's share capital account. In those circumstances, the Commissioner says, the distribution was sourced directly or indirectly from untaxed profits of the Bank.
126 The conclusion to be drawn from this circumstance is that the Bank had a purpose of providing imputation benefits. The imputation system attempts to align companies and their members for tax purposes, but only those members who are the true economic owners of the company, being members who will ultimately take their share of its taxed income. The fact that the Relevant Securities subject the Bank to an expense of deriving profits, from which dividends are paid, to be met from an income source that bears no Australian income tax, indicates that the circumstances of the holders of the Relevant Securities are very far removed from those of the real economic owners of the Bank taking their share of its taxed income. I consider that this circumstance points towards the relevant purpose.
127 The ninth matter, which is described in s 177EA(17)(h), is whether the Distribution in question is equivalent to the receipt by the Taxpayer of interest or of an amount in the nature of, or similar to, interest. The Taxpayer accepts that, in legal form, the Distributions on the Relevant Securities are interest on the Notes component. However, he says, for the purposes of the 1997 Act, they are denied that character and instead, by reference to their economic substance, attributed the character of dividends. In consequence, the Bank is denied a deduction for the interest by s 26-26 and is required to frank the Distributions. Accordingly, he says, the Distribution in question is not in the nature of, or similar to, interest, but is instead a non-share dividend.
128 The payment of the Distribution is a payment of legal form interest, notwithstanding that it is deemed to be a frankable distribution by reason of the operation of other provisions of the tax legislation. The fact that the payment has a particular character for some purposes does not obviate the need to characterise the payment for the purposes of s 177EA(17)(h). There is no reason why a payment that is deemed to be a distribution on non-share equity, by the operation of Division 974, could not also be treated as being equivalent to a payment of interest for the purposes of s 177EA(17)(h).
129 The nature of the payment received by the Taxpayer that is in question can be described as being similar to interest in numerous respects. The payments are regular and in a fixed amount. They are paid in respect of a specific outlay which, as a matter of commerce, the holders of the Relevant Securities expect to be returned to them either in cash or in kind. The rate of the Distribution is variable but is not dependent in any way upon the fortunes of the Bank. Rather, any variation is the result of a variation in the benchmark interest rate, not in the profitability of the Bank. The receipt of a Distribution in question by the Taxpayer is equivalent to the receipt of interest or of an amount in the nature of or similar to interest. I consider that this circumstance points towards the existence of the relevant purpose.
130 The tenth matter, under s 117EA(17)(i), is the period for which the Taxpayer held the Relevant Securities. There is no arrangement whereby the Relevant Securities should be held only briefly. They are held until sale and are not redeemable. I do not consider that this circumstance points to the relevant purpose, but away from it.
131 Finally, under s 177EA(17)(j), any of the matters referred to in s 177D(b)(i) to s 177D(b)(viii) is a relevant circumstance. Many of those matters have no application beyond the extent to which those circumstances have already been taken into account, having regard to the other matters referred to in s 177EA(17).
132 Section 177D(b)(ii) refers to the form and substance of the scheme. The Distributions on the Notes take the form of frankable distributions but, in substance, represent a deductible expense to the Bank. The substance of what they achieve for the Bank, namely deductible and frankable capital, points towards the existence of the relevant purpose.
133 Section 177D(b)(iv) refers to the result in relation to the operation of the tax legislation that, but for Part IVA, would be achieved by the scheme. But for the operation of s 177EA, the Relevant Securities would deliver imputation benefits on deductible interest payments. The Taxpayer says that the result achieved in relation to the operation of the tax legislation is precisely the result mandated by the legislation. He says that the tax character attributed to the Relevant Securities, and to Distributions upon them, is that directed by the deeming effect of Division 974. That is to say, the Bank is denied a deduction for the interest on the Notes and is obliged to attach franking credits to the payments as non-share dividends, or else it would face losing the imputation credits. The legislation, in accordance with the policy evinced in s 974-5, treats the Relevant Securities according to their economic substance, which is equivalent to preference shares. I consider that this matter points towards the relevant purpose.
134 Having regard to all the relevant matters and circumstances, some of which do not point towards the relevant purpose, I consider, on balance, that overall they point towards the purpose of enabling holders of Relevant Securities, such as the Taxpayer, to obtain an imputation benefit. That is a basic and fundamentally important aspect of the terms of the Notes. The characteristics of the Relevant Securities are much more like those of debt than of equity. By issuing the Relevant Securities in New Zealand, the Bank was able to achieve the result that it obtained a deduction in New Zealand in respect of the Distributions on the Relevant Securities, but had the advantage, in terms of cost, of offering Australian residents the imputation benefit.