Thin Capitalisation: exemption - certain special purpose entities

Will an entity be exempt from the thin capitalisation rules in Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997) by virtue of the operation of section 820-39 of the ITAA 1997 where the entity simply on-lends funds to another entity on back-to-back terms?

No. The entity will not be exempt from the thin capitalisation rules in Division 820 of the ITAA 1997 by virtue of the operation of section 820-39 of the ITAA 1997 where the entity simply on-lends funds to another entity on back-to-back terms, as the entity does not satisfy paragraph 820-39(3)(a) of the ITAA 1997.

The entity (entity A) was established for the purpose of financing the construction and operation of a public private partnership infrastructure project.

Entity A has entered into senior debt finance agreements with a syndicate of lenders. The funds obtained by entity A from the syndicate are on-lent to another entity (entity B) under a senior finance agreement.

The terms and conditions of the financing agreement between entity A and entity B are exactly the same as the terms and conditions of the financing agreement between entity A and the syndicate of lenders.

Entity A may enter into further loan agreements with lenders to fund working capital needs of the project.

Entity A does not carry on any type of securitisation activity.

(All legislative references in this Interpretative Decision are to the ITAA 1997 unless otherwise stated.)

Section 820-39 of the ITAA 1997 exempts certain special purpose entities from the application of the thin capitalisation rules in Division 820 of the ITAA 1997. Specifically, subsection 820-39(1) of the ITAA 1997 provides that the thin capitalisation rules do not apply to disallow any debt deductions (as defined in section 820-40 of the ITAA 1997) of an entity for an income year if the entity meets the conditions in subsection 820-39(3) of the ITAA 1997 throughout the income year. The conditions in subsection 820-39(3) of the ITAA 1997 are that: (a) the entity is one established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself); and (b) the total value of debt interests in the entity is at least 50% of the total value of the entity's assets; and (c) the entity is an insolvency-remote special purpose entity according to criteria of an internationally recognised rating agency that are applicable to the entity's circumstances.

The first condition in paragraph 820-39(3)(a) of the ITAA 1997 is that the entity is one established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself).

Considered in isolation, the wording in paragraph 820-39(3)(a) of the ITAA 1997 is very broad and prima facie could cover a wide variety of financing structures where a special purpose entity (SPE) is established for the purpose of managing some or all of the economic risk associated with assets, liabilities or investments.

However, pursuant to the contextual and purposive approach to statutory interpretation, when regard is had to not only the wording of paragraph 820-39(3)(a) of the ITAA 1997 but the legislative context of paragraph 820-39(3)(a) of the ITAA 1997 and the purpose for which it (and more broadly) section 820-39 of the ITAA 1997 was enacted, it is considered that the scope and operation of paragraph 820-39(3)(a) of the ITAA 1997 is limited to only those entities that are established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments of a securitisation transaction or structure. The contextual and purposive approach to statutory interpretation finds support in common law and statute (see for example, K & S Lake City Freighters Pty Ltd v. Gordon & Gotch Ltd (1985) 157 CLR 309; CIC Insurance Ltd v. Bankstown Football Club Ltd (1997) 187 CLR 384; HP Mercantile Pty Ltd v. Commissioner of Taxation (2005) 143 FCR 553; FC of T v. BHP Billiton Ltd & Ors [2011] HCA 17; (2011) 79 ATR; and, Acts Interpretation Act 1901 section 15AA). Paragraph 820-39(3)(a) of the ITAA 1997 does not apply to any other type of entity.

In terms of legislative context, paragraph 820-39(3)(c) of the ITAA 1997 has particular relevance to the interpretation of paragraph 820-39(3)(a) of the ITAA 1997 and supports the view that paragraph 820-39(3)(a) of the ITAA 1997 applies only to entities that are established for the purposes of managing some or all of the economic risk associated with a securitisation transaction or structure.

Paragraph 820-39(3)(c) of the ITAA 1997 requires that the entity is "an insolvency-remote special purpose entity according to criteria of an internationally recognised rating agency that are applicable to the entity's circumstances". One of the fundamental tenets of securitisation is the concept of "insolvency-remoteness". The concept of "insolvency-remoteness" has a special meaning or is specifically associated with a particular type of financing transaction - "securitisation" transactions. While other transactions (for example project financing transactions) may utilise an "insolvency-remote" SPE, it is a concept that is not associated with those transactions but rather is associated only with securitisation transactions.

The relevant criteria of the internationally recognised ratings agencies that is referred to in paragraph 820-39(3)(c) of the ITAA 1997 further supports the view that the concept of an "insolvency-remote" SPE is a fundamental tenet of and associated with securitisation transactions and structures. See, for example, Standard & Poor's Ratings Services' criteria, " Structured Finance - Guide to Legal Issues in Rating Australian Securitization".

Another relevant contextual aspect that supports the view that the type of entity referred to in paragraph 820-39(3)(a) of the ITAA 1997 is a securitisation entity is Note 2 that follows subsection 820-39(4) of the ITAA 1997 and the Note following the definition of 'securitisation vehicle' in subsection 820-942(2) of the ITAA 1997 (with notes, under section 950-100, forming part of the ITAA 1997). The definition of 'securitisation vehicle' in subsection 820-942(2) is relevant to determining an entity's zero capital amount for the purposes of Division 820 of the ITAA 1997.

Note 2, which follows subsection 820-39(4) of the ITAA 1997, states: An entity that does not qualify for the exemption in this section may still be a securitisation vehicle under subsection 820-942(2) of the ITAA 1997, in which case the value of its securitised assets will count towards its zero-capital amount under Subdivision 820-K of the ITAA 1997.

The Note following the definition of 'securitisation vehicle' in subsection 820-942(2) of the ITAA 1997 states: An entity that does not qualify as a securitisation vehicle may be exempt from the thin capitalisation rules under section 820-39 of the ITAA 1997.

The notes following subsection 820-39(4) of the ITAA 1997 and subsection 820-942(2) of the ITAA 1997 illustrate or indicate that there is a connection between the two provisions and that both serve a connected purpose within the broader thin capitalisation regime, that being to capture or cover all types of vehicles or entities that carry on securitisation type activities.

Further contextual support for the view that the scope and operation of paragraph 820-39(3)(a) of the ITAA 1997 is limited to securitisation entities is the heading to section 820-39 of the ITAA 1997 which states "Exemption of certain special purpose entities". The heading, which forms part of the ITAA 1997 pursuant to section 950-100, indicates that the legislature is exempting from the thin capitalisation rules not just any type of SPE but a certain type of SPE that is securitisation entities.

Section 820-39 was inserted into the ITAA 1997 by the Taxation Laws Amendment Act (No 5) 2003 . The purpose for its introduction was to address the somewhat restrictive scope and operation of the definitions of 'securitised asset' and 'securitisation vehicle' in section 820-942 of the ITAA 1997. According to the Explanatory Memorandum (the EM) to the Taxation Laws Amendment Bill (No 5) 2003 which introduced section 820-39 of the ITAA 1997, the definitions of 'securitisation vehicle' and 'securitised asset' meant that a variety of bona fide securitisation vehicles and structures would not be able to take advantage of the benefits of the zero capital treatment provided under section 820-942 of the ITAA 1997. Paragraphs 1.6 and 1.7 of the EM state the following: 1.6 The securitisation industry is complex and dynamic. Many securitisation programs are not available to avail themselves of the benefits of the zero capital treatment provided under the thin capitalisation legislation. In particular, the current definitions do not contemplate origination, warehousing, two-tiered securitisation or synthetic securitisation . Nor do the current rules allow any residual equity holding in a securitisation vehicle. As a consequence, many bona fide securitisation vehicles will inappropriately have a proportion of their interest deductions denied under the thin capitalisation rules (emphasis added). 1.7 To address this, amendments will exclude special purpose entities from the thin capitalisation rules for all or part of the income year provided that the following conditions are met: • the entity is established for the purposes of managing some or all of the economic risk associated with assets, liabilities or investments (whether the entity assumes the risk from another entity or creates the risk itself); • at least 50% of the entity's assets are funded by debt interests; and • the entity is an insolvency remote special purpose entity according to the criteria of an internationally recognised rating agency applicable to the entity's circumstances.

Relevantly, as to the scope and operation of subsection 820-39(3) of the ITAA 1997, paragraph 1.14 of the EM states that: 1.14 The three conditions in subsection 820-39(3) of the ITAA 1997 seek to cover a broad and ever expanding range of securitisation activity and structures . For example, the conditions seek to include a warehousing type entity where securitised assets are temporarily placed pending their transfer to another entity. The conditions also seek to cover a two tiered securitisation structure where one entity holds the securitised assets and the other entity issues the debt interests (emphasis added).

As the EM makes clear, the legislative amendments to the thin capitalisation regime introducing section 820-39 of the ITAA 1997 provide an expansion to the treatment of bona fide securitisation vehicles. The inclusion of the conditions in subsection 820-39(3) of the ITAA 1997 were thus intended to cover all securitisation entities that would otherwise not have been caught by section 820-942 of the ITAA 1997 including those securitisation entities that create the risk themselves.

The Senate Economics Legislation Committee report into the Provisions of the Taxation Laws Amendment Bill (No. 5) 2003 (the SELC report) echoes the statements made in the EM regarding the scope and purpose of section 820-39 of the ITAA 1997. For example, paragraphs 2.16 and 2.21 of the SELC report relevantly states: 2.16 This Bill, will, if passed, exempt certain special purpose entities, in particular, ' securitisation vehicles' from the operation of the thin capitalisation regime. 2.21 As explained in the explanatory memorandum, this condition [paragraph 820-39(3)(c) of the ITAA 1997] seeks to ensure that the entity (that is the securitisation vehicle ) meets or would meet an internationally recognised rating agency's requirements for an insolvency remote special purpose entity (that is the possibility of the entity becoming insolvent is remote). (emphasis added)

In relation to paragraph 820-39(3)(a) of the ITAA 1997 specifically, the EM states the following at paragraph 1.8: 1.8 The first condition is a purpose test that seeks to exclude entities that are not specifically established for what might be commonly referred to as securitisation or origination activity. It also seeks to exclude entities that undertake any activities not related to the process of securitisation or origination. The first item seeks to cover items and risks that could be securitised or originated. For example, it covers a straightforward arrangement where assets are purchased by a special purpose entity. It also covers more complex arrangements, for example, where the risk associated with the assets is acquired by a special purpose entity but the underlying assets remain on the balance sheet of the originating entity.

Whilst the EM refers to securitisation or origination this must be understood in the context that paragraph 820-39(3)(a) of the ITAA 1997 excludes entities that undertake any activities not specifically related to the process of securitisation or origination as part of a securitisation program. This is consistent with the syntax, legislative context and policy of section 820-39 of the ITAA 1997.

Since section 820-39 of the ITAA 1997 generally and paragraph 820-39(3)(a) of the ITAA 1997 specifically is intended to apply to and recognise a broad range of securitisation activities performed by securitisation vehicles, it is important to ascertain what a securitisation is as commercially understood in order to ascertain whether the activities of the entity in the current case fall within the scope of paragraph 820-39(3)(a) of the ITAA 1997.

Relevantly, for current purposes, the SELC report (on page 7) defines 'securitisation' in its simplest form as: ...a financial institution selling some of its mortgages, mortgage loans or receivables to a special purpose entity. The vehicle acquires the loans using debt raised from third party investors through bonds - hence securitisation - issuing securities to fund the acquisition of those assets. This removes the assets from the financial institution's balance sheet and lowers the cost of the funds.

Securitisation has also been defined by the Reserve Bank of Australia's bi-annual publication, Financial Stability Review , which is available via the RBA's website, www.rba.gov.au. In an article titled, 'Asset Securitisation in Australia', the RBA define asset securitisation as: Asset securitisation - the process of converting a pool of illiquid assets, such as residential mortgages, into tradeable securities....

In a standard securitisation arrangement, the SPE will usually purchase assets from an originator or arranger. However, in more complex arrangements for example, the entity may acquire or originate assets into a warehouse portfolio for an interim period pending securitisation of those assets. The SPE will then, as part of a securitisation program, transfer the assets from the warehouse into a securitisation portfolio. An essential feature of these arrangements is that assets, which individually are generally illiquid, are placed in a securitisation portfolio to enable the SPE to raise finance by issuing debt securities.

In the present case, the taxpayer (entity A) was established for the purpose of financing the construction and ongoing operation of the project. Entity A has borrowed funds from a syndicate of lenders under a financing arrangement and on-lent those funds to another entity (entity B) on exactly the same terms and conditions as the financing arrangement with the syndicate of lenders. Entity A has not entered into a securitisation arrangement as commonly understood, irrespective of any risk it may have assumed or created under the financing structure. It is not a securitisation entity. Rather, entity A is a mere conduit, simply borrowing funds and on-lending those funds to another entity.

Accordingly, entity A does not satisfy paragraph 820-39(3)(a) of the ITAA 1997 and it will therefore not obtain the benefit of the exclusion from the thin capitalisation rules provided by section 820-39 of the ITAA 1997.