Interest deduction on funds borrowed in connection with the acquisition of assets from a foreign controlled Australian company

Is the interest on funds borrowed by the taxpayer company to redeem the preference shares of the taxpayer company held by a related company, where both companies have the same foreign controller, an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The interest on funds borrowed from a related company to redeem the preference shares by the taxpayer company, where both companies have the same foreign controller, is not an allowable deduction under section 8-1 of the ITAA 1997 as section 159GZZE of the Income Tax Assessment Act 1936 (ITAA 1936) prevents a deduction.

Company A, company B and company X are all wholly owned subsidiaries of company Y.

Company A, company B are residents of Australia for income tax purposes.

Company X and company Y are non residents of Australia.

The issued preference shares in company A, the taxpayer company, are owned by company B.

Company A borrows an amount from company X in the 1998-99 income year to redeem the preference shares owned by company B. The preference shares are cancelled soon after redemption.

Company A pays interest to company X on the money borrowed to redeem the preference shares.

Section 8-1 of the ITAA 1997 allows deductions for any loss or outgoing to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for the purpose of gaining or producing assessable income. However, a deduction is not allowable for a loss or outgoing if it is of a capital, private or domestic nature incurred in relation to producing exempt income or specifically prevented by a provision of the ITAA 1936 or ITAA 1997.

Subsection 8-5(2) of the ITAA 1997 provides that some provisions of the ITAA 1936 or the ITAA 1997 prevent or limit deduction of an otherwise deductible amount.

The provisions which prevent or limit an otherwise deductible amount are listed in section 12-5 of the ITAA 1997. Included in this list is section 159GZZE of the ITAA 1936 which deals with limitation on deductions relating to interest on debt creation involving non-residents.

The Explanatory Memorandum (EM) introducing Division 16G in Part III of the ITAA 1936 stated that the Division will deny interest deductions on debt creation involving non-residents in specified circumstances. The EM went on to state that:

the interest affected is that incurred after 30 June 1987 on amounts owing in connection with the acquisition of assets from "foreign controllers" of Australian companies or from foreign controlled Australian companies. Put broadly, restructuring of foreign controlled investments in companies will not be permitted to be financed by interest-bearing debt to the extent that there is no change in the ultimate beneficial ownership of any assets transferred under the restructure.

Section 159GZZE of the ITAA 1936 provides the mechanism for determining the amount of non-deductible interest. It provides that the section applies where: • an amount of interest is allowable as a deduction in respect of an amount owing by a taxpayer company 'in connection with' the 'acquisition' of an 'asset' from another company ('eligible seller'), and • there is a 'foreign controller' of the buyer and the eligible seller of an asset, or the foreign controller is either the buyer or eligible seller.

The term 'asset' is defined in section 159GZY of the ITAA 1936 very broadly to mean any form of property which include preference shares. The EM states that the phrase 'in connection with' is used in very broad terms in paragraph 159GZZE(1)(b) of the ITAA 1936.

The word 'acquisition' is not defined in the legislation and it takes its ordinary meaning. The Shorter Oxford English Dictionary, 1993, 3rd edn, Oxford Clarendon Press defines the verb 'to acquire' as '1. to gain, obtain or get as one's own, to gain the ownership of (by one's own exertions or qualities); 2. to receive, or get as one's own (without reference to the manner), to come into possession of'. The Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library, Pty Ltd, NSW gives a similar definition ( Allina Pty Ltd v. Federal Commissioner of Taxation (1991) 28 FCR 203; 91 ATC 4195; (1991) 21 ATR 1320). The meaning of the term 'acquisition' varies depending on the context of its usage (see McDonald's Australia Holdings Ltd and Another v. Commissioner of State Revenue [2004] QSC 357).

There was an 'acquisition of an asset' in this case at the time of the redemption of the preference shares by company A.

Under section 159GZZA of the ITAA 1936, a person will be a 'foreign controller' of a company if that person is both a non-resident and has a 'capital entitlement factor' in relation to the company amounting to at least 50%. Subsection 159GZZ(1) of the ITAA 1936 provides that the capital entitlement factor of a person in relation to a company will be determined on the basis of a notional distribution of capital by the company. The capital entitlement factor will be the percentage of the notionally distributed capital that the person would be beneficially entitled to receive either directly or indirectly.

Company Y is the foreign controller as it is both a non-resident and has a direct or indirect capital entitlement factor in relation to company A of 100%.

Paragraph 159GZZE(1)(c) of the ITAA 1936 describes three alternative situations that are pre-conditions to the application of the provision in relation to an acquisition: • immediately after the acquisition of the asset, the eligible seller was a non-resident company foreign controller of the taxpayer company • the taxpayer company was a foreign controller of the eligible seller company immediately before the acquisition, or • where neither of the above two situations apply, a person was foreign controller of the eligible seller company immediately before the acquisition, and a foreign controller of the taxpayer buyer company immediately after the acquisition (known as a 'common foreign controller').

The third situation described in paragraph 159GZZE(1)(c) of the ITAA 1936 is satisfied in this case as company A, company B and company X have a common foreign controller, company Y.

Subsection 159GZZE(4) of the ITAA 1936 contains definitions and formula used to reduce interest deductions.

The application of the formula given in subsection 159GZZE(4) of the ITAA 1936 will result in all the interest relating to the borrowing to redeem the preference shares as not an allowable deduction.

Section 159GZZF of the ITAA 1936 provides for the exclusion of the application of the above provisions to those transactions not normally regarded as corporate restructures. None of the exclusion provisions applies in this case.

The restructuring of the capital structure of company A was financed by interest bearing debt. Consequently, section 159GZZE of the ITAA 1936 applies as the interest incurred by the taxpayer company was in respect of an amount owing in connection with the acquisition of an asset where there was a 'foreign controller' of the buyer and the eligible seller.

Accordingly, the interest incurred by the taxpayer company in respect of borrowing in connection with the acquisition of the preference shares is not deductible under section 8-1 of the ITAA 1997. Note: Division 16G of the ITAA 1936 was repealed effective from 1 July 2001.