On 14 September 2005 a majority of the Full Federal Court in Macquarie Finance v Federal Commissioner of Taxation held that interest on certain debentures was not deductible, but a different majority held that the general anti-avoidance rule, Part IVA, would not have applied if the interest had been deductible.
The decision should be treated with caution at present, given the application for special leave to appeal to the High Court which was filed 11 October 2005. While the taxpayer lost on general interest deductibility, the decision provides some positive signs about the attitude of the Federal Court to applying Part IVA to commercially driven transactions. Bearing in mind that the Court really only determined the issue on a hypothetical basis (given that the interest was not deductible in any event), and Hill J’s reluctant view (at first instance), the comments on Part IVA in the case must read that Part IVA would have applied, if the interest had been deductible, and the view of a minority judge of the Full Federal Court that Part IVA would apply.
That said, the case could be of relevance on the issue of penalties in Part IVA cases more generally. Specifically, the split views of four Federal Court judges and the hypothetical nature of some of their findings on Part IVA is a testament to the potential complexity for the Commissioner in arriving at the unequivocal conclusion that Part IVA does apply and that a taxpayer does not have a reasonably arguable position.
Facts
The case considered the deductibility of interest paid on “Macquarie Income Securities” (MIS), which were issued in 1999. These securities consisted of unsecured perpetual debentures issued by Macquarie Finance Limited (MFL), which were stapled to non-cumulative preference shares issued by Macquarie Bank Limited (MBL).
The manner in which the funding was obtained firstly involved an issue of fully paid preference shares in the capital of MBL to Deutsche (the underwriter). Holders of the preference shares were not entitled to dividends unless a “payment direction event” occurred - this would occur in the event of liquidation of MBL or MFL, if either company acknowledged that it could not pay its debts, if MBL gave notice that it required all moneys owing on the notes to be paid to it, or the Australian Prudential Regulation Authority (APRA) made certain written determinations about MBL’s Tier 2 Capital Ratio or Total Capital Adequacy Ratio.
Dividends were not cumulative, but Macquarie was not to declare a dividend on any ordinary share or share ranking junior to the preference shares, until two consecutive dividends were paid on the preference shares, or with the written approval of APRA, if Macquarie elected to make payment of the amount unpaid of the last two such dividends.
At the same time as the preference shares were issued, MFL issued Notes - unsecured perpetual debt obligations - under a debenture trust deed. Under the deed, MFL was to pay all moneys due under the Notes directly to investors unless a payment redirection event occurred. Interest - calculated at 1.7% plus a base interest rate - was to be paid quarterly, but was not payable or deemed to accrue if it exceeded the distributable profits of MBL, or if certain other events transpired.
Critical to the structure was a “procurement agreement” under which MBL was to pay Deutsche an amount equal to the face value of the notes and in this event Deutsche would give a payment direction which required that all monies payable under the notes would be paid to MBL or as it directed. The payment direction and the payment by MBL had the consequence that MBL reimbursed to Deutsche the money Deutsche subscribed for either the preference shares or the notes.
There was no obligation on MBL or MFL to redeem the notes or otherwise repay investors. However, MBL could, after five years from the issue date, at its option repurchase each MIS. Similarly, MBL could repurchase the securities earlier than the five year period in certain limited circumstances.
Taxpayer’s argument
The taxpayer argued that the purpose of issuing the securities was to fund operations in a way that was acceptable to the rating agencies, and would not result in downgrade of MBL. Funding via the MIS was particularly advantageous, given its standing as Tier 1 capital, and the resulting lengthening of MBL’s debt profile. Furthermore, the funds were actually lent by MFL to Macquarie Leasing. In this respect it was noted that MFL was used as the issuer of the debentures (rather than MBL) as MBL could not have advanced funds directly to Macquarie Leasing given that it was limited by APRA as to the amount it could advance to its subsidiaries.
Commissioner’s argument
The Commissioner argued that interest payments made in respect of the debentures were not deductible on the basis that:
- the interest was not incurred in deriving assessable income of MFL, as MFL was simply a conduit and the advantage secured by the interest was an advantage to MBL, rather than to MFL
- the expenses incurred were not "interest" on the basis that the underlying debt would not be repaid to the MIS holders, and what would get paid was essentially the profit of MBL
- no deduction was available under the general deduction provision in the income tax legislation, being s8-1 of the Income Tax Assessment Act 1997 as the expense was capital in nature
- the claiming of the interest deductions was subject to Part IVA of the Income Tax Assessment Act 1936, being the general anti-avoidance rule
- the convertible note provisions applied to deny interest deductions.
Federal Court decision
On appeal to the Federal Court, Hill J held that the interest was not deductible, and commented that if he had held that interest was deductible, he would (with reluctance) have applied the general anti-avoidance rule, Part IVA.
Appeal to the Full Federal Court
On the taxpayer’s appeal to the Full Federal Court, a majority dismissed the appeal and found that no part of the interest payable was deductible. A different majority of the Court also found (albeit tentatively on the part of French J) that the general anti-avoidance provisions in Part IVA of the ITAA 1936 would not have applied had the payment been deductible. The table below summarises the findings of each judge:
 | Deductible? | P |
| French J | No | No |
| Hely J | Yes | No |
| Gyles J | No | Yes |
Deductibility of interest payments
French J held that the payments were not deductible as they were not incurred by the taxpayer in gaining or producing assessable income nor necessarily incurred in carrying on a business for that purpose. His Honour found that at the time the transactions were entered into, the likely effect of the various transaction documents was to enable MBL to meet a need to raise Tier 1 capital for its ongoing operation, and the way that MFL became involved in the arrangements indicates that it was there to serve the purposes of MBL, and that those purposes could be properly attributed to it. The liability of MFL to pay “interest” on the notes which it issued was not tied to any income generating purposes of its own.
His Honour further noted that the application of the interest moneys was effectively under the control of MBL from the commencement of the transactions, and the relationship of the interest payments to dividends payable on the preference shares makes them as outgoings relevant to the raising of permanent additional capital for the whole group, rather than as a recurrent cost of the loan. Although it was unnecessary to consider the issue in view of his Honour’s finding that the payments were not incurred in gaining or producing assessable income, French J stated that on a wider view, the payments made by MFL to the noteholders were, by way of expenditure outlaid, to secure a permanent capital increase for MBL and associated companies, and would accordingly be denied deductibility on the basis that the payments were of a capital nature.
Gyles J agreed that the payments were not deductible because they were not incurred in gaining or producing assessable income, or necessarily incurred by MFL in carrying on a business for that purpose. His Honour also agreed with the judgment of the primary judge (Hill J) that the payments were an affair of capital.
His Honour found that the primary judge was correct in finding that the stapling of the preference shares and notes was a key feature of the transaction that could not be ignored - MFL received money without an obligation to repay the investor, and received a permanent advantage of the money unless it was obliged to pay it to its parent company by the unilateral decision of MBL at which time MBL would obtain the permanent advantage of the money. Payment of the interest to the investor did not secure the continued retention of the money as against the investor. This was said to be supported by the fact that the transaction resulted in the raising of Tier 1 capital (which is in the nature of capital, regardless of the label attached to it) by MBL which was the object of the transaction.
Hely J was in the minority on the deductibility issue and held that the interest payments were deductible under the general deduction provision, and were not capital in nature.
His Honour examined the transaction documents and the rights and liabilities created to determine the essential character of the outgoing. His Honour indicated that an effect of the overall transaction (ie the preference shares and notes together) was that MBL increased its Tier 1 capital (thereby enabling MBL to expand its operations) by the issue of the preference shares on which no dividend was payable until the occurrence of the Payment Direction Event, which MBL could generate at its own option. However, looking at the overall transaction did not detract from the business purpose for which the obligations under the MIS were incurred from the perspective of MFL, which was the raising of money from investors for use in MFL’s business.
In relation to the question of whether the payments were capital in nature, Hely J examined the transaction from MFL’s perspective (finding that the perspective and identity of the person to whom the obligations are owed is irrelevant) and noted that MFL remains liable to make interest payments on the notes, and to pay the monies owing in respect of the notes according to the terms of issue, either to the noteholders or to MBL on the occurrence of a Payment Direction.
The character of the advantage sought by the interest payments was stated to secure the continued use by MBL of the funds raised by the issue of the MIS - the ability of MBL to switch from paying interest paid by MFL to dividends paid by MBL on the preference shares was found not to affect the characterisation of MFL’s liability on the notes whilst they remained outstanding. Hely J stated that the interest payments constituted “recurring expenditure to meet a continuous demand, as opposed to expenditure made once and for all.” The payments were “regular outlays made by MFL to obtain debt finance which MFL used to make advances on which MFL derived assessable income” and the capping of the dividends payable by MBL did not mean that MFL’s obligation to pay interest was of a capital nature.
Application of Part IVA
Gyles J was the only judge who found that Part IVA of the ITAA 1936, would apply to the arrangement had the interest payments been deductible. Rather than providing a detailed analysis, his Honour merely made the comment that he consider that Hill J’s reasoning was in fact too favourable to the taxpayer, and went on to make some brief statements as to why he thought Part IVA would have applied. His Honour stated that any counterfactual in the case must involve the raising of Tier 1 capital by MBL, and no counterfactual would involve deductibility for payments made by it on behalf of MBL to investors, as no debt or loan instrument upon which interest would be paid on revenue account would qualify. Additionally, the fact that MFL was inserted into the arrangements at a late stage for the purpose of obtaining deductions for payments to investors, is relevant to the Part IVA finding.
In contrast, Hely J, in an extensive analysis of Part IVA, concluded that a reasonable person would conclude, having regard to the eight factors in s177D(b) of the ITAA 1936, that the dominant purpose of those engaged in the issue of the MIS on the particular terms on which the issue was made was to secure to the MBL group all of the commercial advantages associated with debt financing (including, but not limited to tax deductibility of interest), whilst at the same time qualifying as Tier 1 capital. As such, his Honour concluded that the Commissioner was not authorised to make a determination under Part IVA to disallow MFL a deduction for interest. French J stated that he would agree with Hely J on the Part IVA issue, but considered that as the issue was only hypothetical (because the interest was not deductible under s8-1), then the Court’s decision on Part IVA was at best a provisional statement of opinion rather than a true judicial determination.
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