Under the income tax rules, returns on debt interests (e.g. interest) are a pre-tax expense and deductible. On the other hand, returns on equity interests (e.g. dividends) are non-deductible (although they may be frankable).

Section 974-80 of the Income Tax Assessment Act 1997 was introduced in July 2001 as an integrity provision to ensure that an equity interest could not be disguised as a debt interest - i.e. where the debt interest in the issuing company was used to fund equity returns to an ultimate investor through related entities.

The Government was originally concerned that a company could obtain tax benefits associated with issuing debt interests, by interposing related party entities between itself and an investor, whereby debt instruments would be issued to those interposed entities. This strategy would create artificial deductions to the issuer company, where the ultimate investor would hold an equity interest in the interposed entity.

The Government originally intended that the integrity provision would only apply in limited circumstances where an ultimate investor had an “effective equity interest” in the relevant company (through the interposed entities). However, the wording of the integrity provision is currently broadly drafted and the Australian Taxation Office (“ATO”) has previously issued a discussion paper outlining a view that the provisions could apply well beyond the original policy intent to ordinary funding transactions.

The Government has announced in the Budget that it will amend the integrity provision to limit its scope and to ensure that the provision will only apply to arrangements where both the purpose and effect is that the ultimate investor has, in substance, an equity interest in the issuer company. In addition, the provision will be amended to give the ATO a discretion not to apply the section where it would be unreasonable for the provision to apply. The change will be retrospective with effect from 1 July 2001 (being the date of commencement of the debt/equity tax rules).

It is noted that the ATO has recently been targeting certain funding arrangements of stapled structures using the current drafting of the integrity provision. The announcement is silent as to whether the proposed retrospective amendments will change the ATO's approach in respect of audits and reviews being conducted in relation to these types of funding arrangements.