Issue
For the purpose of deducting a dividend pursuant to subsection 25-85(3) of the Income Tax Assessment Act 1997 (ITAA 1997), is the annually compounded internal rate of return (IRR) under subsection 25-85(5) of the ITAA 1997 calculated in each income year in which a dividend is paid, having regard to the amount of that dividend and the amount of dividends paid in previous years?
Decision
Yes. For the purpose of deducting a dividend pursuant to subsection 25-85(3) of the ITAA 1997, the annually compounded IRR under subsection 25-85(5) of the ITAA 1997 is to be calculated in each income year in which a dividend is paid, having regard to the amount of that dividend and the amount of dividends paid in previous years. This is the case irrespective of whether the dividends are cumulative or not.
Facts
A resident Australian Company issues a redeemable preference share (RPS) that is characterised as a debt interest under Division 974 of the ITAA 1997. It has the following terms:- • issue price $100. • dividends will be payable annually at the rate of the Bank Bill Swap Rate (BBSW) provided the company has sufficient profits. • the BBSW rate at the date of issue is 10.00%. • the 'benchmark rate of return' for the RPS is 8.50%. • the dividends are cumulative, with unpaid dividends payable in a later year of income provided the company has sufficient profits. • redemption date of the RPS is five years from its issue date, at which time it will be automatically redeemed for the issue price.
Dividends were not paid on the RPS in Year 3 due to insufficient profits but were deferred and paid in Year 4 together with the Year 4 dividend.
The funds so raised are used by the Company in gaining or producing its assessable income.
Reasons for Decision
Section 25-85 of the ITAA 1997 allows certain returns in respect of debt interests to be deductible (subject to the limit of the benchmark rate of return increased by 150 basis points) where, as in this case, the deduction would not otherwise meet the general deductibility criteria under section 8-1 of the ITAA 1997.
Subsection 25-85(3) of the ITAA 1997 provides a number of conditions that must be satisfied for the return to be deductible in an income year if the return under the debt interest is a dividend. These conditions were satisfied in respect of the dividends paid on the RPSs.
Subsection 25-85(5) of the ITAA 1997 determines the rate that is deductible to the issuer in respect of a return that is paid under the debt interest. The subsection stipulates that: Subject to regulations made for the purposes of subsection (6), subsections (2) and (3) do not apply to the return to the extent to which the annually compounded internal rate of return exceeds the benchmark rate of return for the interest increased by 150 basis points.
The term 'annually compounded internal rate of return' is not defined in the ITAA 1997. Broadly, the annually compounded IRR is the annual rate at which the amount originally invested, together with all the cash flows, accumulates to equal the value of the assets at the end of the period (alternatively the discount rate or opportunity cost of capital at which the net present value of a transaction is equal to zero).
The words in section 25-85 of the ITAA 1997, in particular subsection 25-85(5) of the ITAA 1997, show a clear intention that one must look at the actual return in the year in which the return is paid in calculating an annually compounding IRR. This is supported by Example 2.14 in the explanatory memorandum to the Bill introducing section 25-85 (New Business Tax System (Debt and Equity) Bill 2001).
The annually compounded IRR for the RPS at the time of issue is 10.00% p.a. This is calculated on the following cash flow pattern (expected): Year 0 -$100 (issue price) 1 $10 (BBSW = 10.00%; therefore 10.00% x $100 ) 2 $10 3 $10 4 $10 5 $110
Year
0 | -$100 (issue price)
1 | $10 (BBSW = 10.00%; therefore 10.00% x $100 )
2 | $10
3 | $10
4 | $10
5 | $110
However, the annually compounded IRR must be calculated on an annual basis for each year of income in which a dividend is paid.
Applying this conclusion to the Year 4 dividend payment has the following outcome. In Year 1 the annually compounded IRR is still 10.00% as, at that point in time, the deferral of the third year dividend payment to the fourth year is not known or expected.
However, as stated in the facts, in year 4 the dividend payment is $20 because the Year 3 dividend payment was missed and thus the annually compounded IRR is calculated in that year using the following cash flow pattern (actual and expected): Year 0 -$100 (issue price) 1 $10 (BBSW = 10.00%; therefore 10.00% x $100) 2 $10 3 $0 4 $20 5 $110
Year
0 | -$100 (issue price)
1 | $10 (BBSW = 10.00%; therefore 10.00% x $100)
2 | $10
3 | $0
4 | $20
5 | $110
Annual Compounded IRR = 9.82%
The annually compounded IRR in Year 4 is 9.82% p.a. This rate is then compared to the benchmark rate of return as increased by 150 basis points in ascertaining the amount that will be deductible pursuant to section 25-85 of the ITAA 1997. The benchmark rate together with the 150 basis points is 10.00%. As the annually compounded rate calculated in year 4 (9.82%) is less than the benchmark rate adjusted by 150 basis points (10.00%), the entire $20 dividend is allowed as a deduction in that year of income.