Macquarie Finance what is interest and when is it deductible by alendar


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									      Macquarie Finance: what is interest and when is it deductible
The decision of Hill J in Macquarie Finance Limited v Commissioner of Taxation (14 September
2004, Federal Court) addressed a number of key issues – broadly, the nature of interest and when
it is deductible, the operation of the convertible note rules, and the operation of the anti-avoidance
rules contained in Part IVA of the Tax Act.

The purpose of this note is to briefly comment on two of the issues addressed by Hill J – the nature
of interest and when it is deductible.

The case relates to stapled income securities issued by Macquarie Bank, being fully paid
preference shares issued by Macquarie Bank Limited and a note issued by Macquarie Finance
Limited, and the deductibility of 'interest' payments made by Macquarie Finance Limited on the
notes. Hill J held that the 'interest' payments were not deductible on the basis that they were
capital in nature as they secured an enduring benefit (namely, the raising of Tier 1 capital for
Macquarie Bank Limited).

It is noted that:

(a)      the decision in Macquarie Finance supports key aspects of the Commissioner's tax rulings
         on stapled securities and perpetual debt;

(b)      the Macquarie income securities were issued prior to the introduction of the Debt/Equity
         Rules in the Tax Act. In this respect it can be said that the decision in Macquarie Finance
         is of limited value going forward, as the deductibility of 'interest' on perpetual instruments
         would now generally be determined by reference to whether the instruments were
         classified as debt or equity under the Debt/Equity Rules. However an understanding of
         'what is interest and when it is deductible' will continue to be highly relevant in many
         contexts when analysing and structuring transactions.

What is interest?
On the issue of what is interest, Hill J said that:

•        Interest is ordinarily a recurrent or periodic payment securing not an advantage of an
         enduring kind, but rather, securing the use of the money during the term of the loan;

•        Interest has variously been described as a payment made by a borrower for the use of the
         money borrowed and as recompense for the lender for being denied use of the money for
         the term of the loan.

What these descriptions establish is that it will generally be necessary for there to be a borrowing
before the return can be regarded as interest, and that the concept of borrowing presupposes that
the lender is entitled to a return of the money lent. Hence, Hill J found that it was questionable
whether a perpetual instrument such as the Macquarie income securities could be regarded as a
borrowing and whether the return on such an instrument could be regarded as interest. However
Hill J expressly rejected the idea that the 'interest' return on a perpetual instrument could not be
allowed as a deduction. Indeed, the Debt/Equity Rules have now enshrined an entitlement to a
deduction for an 'interest' return where the permanent nature of the instrument would otherwise

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cause the deduction to be denied (section 25-85), provided the instrument qualifies as debt under
the Debt/Equity Rules.

When will interest be deductible?
On the question of when interest will be deductible, Hill J said the following:

•       Ordinarily, interest will be allowed as a deduction if it is incurred in the course of an
        income-producing activity or business.

•       However, the question of deductibility of interest is not determined by the label which the
        parties attach to the outgoing. The tax law does not require that an amount be interest or
        that there be a borrowing before a deduction is allowed for what is called 'interest'. Rather,
        independent of the label, the question of deductibility is to be determined by reference to
        the fundamental test laid down in section 8-1 of the Tax Act. Hence, the question of
        whether the return on a perpetual instrument is deductible is to be determined by that test
        and not by reference to the 'interest' label. According to Hill J, an 'interest' return will not
        necessarily cease to qualify as an allowable deduction merely because it is payable on
        non-redeemable or perpetual instrument.

•       Interest will not be deductible to the extent that it is capital in nature. The significant point
        here is that Hill J looked to the substance of the overall arrangement in concluding that the
        'interest' return on the Macquarie income securities was capital and therefore not
        deductible. The legal form of the notes could not be viewed in isolation – the stapling of
        the shares and the notes, and the fact that the overall structure was recognised as raising
        permanent Tier 1 capital meant that, as a matter of substance, the 'interest' return was paid
        to acquire the permanent use of investors' funds rather than the use of those funds for a
        limited term (as is the case with a true borrowing on which deductible interest is paid).

Please do not hesitate to contact either of us if you wish to discuss any of these issues.

Martin Fry                                       Brad Schwarz
Partner                                          Senior Associate                  
Tel 61 3 9613 8610                               Tel 61 3 9613 8264

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