Significant amendments to section 8F of the Income Tax Act 1962, due to apply from 1 April 2014, will adversely affect many subordination agreements. This arises from an addition to the definition of “hybrid equity instrument” in section 8F.
If an instrument falls within the definition of “hybrid debt instrument”, the effect is that the interest expense is deemed for both debtor and creditor to be a dividend in specie, which means that the debtor is liable for the dividends tax, and the interest is not deductible for tax purposes. The dividend in specie is deemed to accrue to the creditor and to have been declared and paid by the debtor on the last day of the debtor’s year of assessment.
The definition has been substantially amended from 1 April 2014 and differs in certain important respects from its predecessor. If any one or more of the following three conditions is present, the instrument is a hybrid debt instrument. These conditions are that:
(a) the debtor is in the year of assessment entitled or obliged to convert or exchange the instrument for shares, unless the value of the shares is equal to that of the instrument; or
(b) the obligation to pay an amount in respect of the instrument is conditional upon the market value of the assets being not less than that of the liabilities of the company or
(c) the instrument is between connected persons and there is no obligation to redeem the instrument within 30 years (unless it is a demand instrument).
The condition likely to cause difficulties in relation to subordination agreements is (b). Every subordination agreement contains the obvious clause to the effect that the creditor (usually although not necessarily a connected person in relation to the debtor) subordinates its claim in favour of outside creditors. There can be no quibble with this provision and no tax consequences arise from it.
It is the second clause, encountered from time to time, that threatens to link subordination agreements to section 8F. This is where the creditor undertakes not to demand or sue for or accept repayment of all or any part of the subordinated debt until the value of the assets exceeds that of the liabilities. The wording of this typical clause is so similar to that of (b) in the definition of “hybrid debt instrument” that it is unlikely to be a coincidence.
The Explanatory Memorandum to the Taxation Laws Amendment Act 2013 does not refer to subordination agreements as such, and perhaps the similarity is a coincidence. If so, the unintended consequence is significant and will potentially affect many companies that need to conclude subordination agreements with their shareholders, not for tax avoidance purposes but to pass the solvency test or satisfy outside creditors seeking security.
The main point is that lenders and borrowers need to be alive to the possible inadvertent intrusion of section 8F into commercially desirable subordination agreements.
