Stapled stock provisions (SOP 224)

Overview

Stapled stock is a debt security attached to a share so that the two must be traded together. Supplementary Order Paper No 224 (SOP) proposes to treat the debt component (referred to here as “stapled debt”) of certain stapled stock instruments as shares for tax purposes, with the interest treated as dividends. The purpose of this proposal is to protect the tax base from excessive interest deductions achieved through these arrangements.

Nearly all modern company tax systems hinge on a distinction between debt (money lent, with an expectation of regular income and/or repayment) and equity. “Equity” implies participation in the profits and losses of a company (hence “equity risk”), usually through ordinary shares.

New Zealand’s established practice is to tax debt and shares based on their legal form, rather than their economic substance, but with certain specific exceptions where legislation overrides legal form. For example, a “debt” that pays a return dependent on the profits of the company is treated as a share for tax purposes.

The government has become concerned that, under the current law, stapled stock could be treated as shares for commercial purposes (such as accounting, regulation and credit rating), but as debt for tax purposes. Even though the interest payment is effectively a substitute for a dividend, the interest would be deductible. Stapled stock could lead to significant revenue loss if issued to non-resident and tax-exempt investors.

The matter became urgent in early 2008 when several large, widely held companies were actively considering public issues of debt legally stapled to ordinary shares. Officials estimated that these arrangements would have an annual revenue cost in the order of $90 million. The proposed new rule was announced on 25 February 2008 and was to apply from that date.

The scope of the proposed rule is narrow. Stapled stock has not previously been issued, to our knowledge, by a listed New Zealand company. Arrangements that do not result in interest deductions, and debt stapled to a share before the announcement, are excluded. As a result of consultation in mid-2008, the rule excludes arrangements in which the issuing company is not a party, or debt is stapled only to a fixed-rate share (a debt substitute).

Submissions on the SOP focussed mainly on the need to target arrangements that present a genuine risk to the tax base, and to avoid unintended consequences. As a result, officials recommend some further narrowing of the scope of the new rules, along with technical changes to ensure that the rules operate as intended.

Issue: Reconsider the need for the stapled stock rule

Submissions

(32 – KPMG, 68 & 68A – Corporate Taxpayers Group)

The rule should be reconsidered on the basis that:

The changes were introduced in an ad hoc, hasty manner that could result in poor policy and undermine investor confidence.
Stapled stock is used in other countries for non-tax reasons: any tax minimisation effects are only a by-product.
Companies can minimise tax by gearing up their debt instead of stapling.
The changes could increase financing and transaction costs.
The proposals favour companies with a non-resident parent, able to have up to 75 percent debt under thin capitalisation rules, over widely held New Zealand-owned companies that would issue shareholder debt as stapled debt for commercial reasons. (KPMG)

The rule applies more widely than is justified and will undermine investor confidence in the tax policy process. It will create a further preference for 100 percent ownership of New Zealand businesses by non-residents because closely held companies can achieve the same tax effect without “legal” stapling. As currently drafted, all shareholder debt in a public company (which by definition requires that debt to be stapled) would become “offensive” from a policy perspective. (Corporate Taxpayers Group)

Given that the “potentially offending transactions” (the arrangements contemplated in early 2008) are now no longer proposed, the measure should be removed from the bill and subject to further consultation to develop the correct framework upon which reform should be based. (Corporate Taxpayers Group)

Comment

Officials agree that there is a need to further reduce the scope of the stapled stock rule. Our recommendations are set out under the more specific submission points that follow.

The potential revenue cost of the contemplated transactions was discussed in the section “Overview”. Officials consider that the new rule will not have the consequences claimed in submissions for the following reasons:

The very narrow scope, including only newly stapled instruments of a type that has not, to our knowledge, been issued by a listed New Zealand company.
The rule is consistent with the past practice of recharacterising certain specific financial instruments at the extreme margin.
Officials consulted with taxpayers on draft legislation, and the select committee process has provided a further opportunity for taxpayers to make submissions.

The argument that companies can, instead of issuing stapled stock, increase their debt by simply increasing their gearing overlooks an important fact. Stapled stock allows companies to overcome normal commercial, regulatory and tax law barriers to excessive debt and interest deductions. If companies with a non-resident parent enjoy an advantage when issuing shareholder debt, any such advantage is long-standing, is not the result of the current proposal, and is constrained by other tax rules.

Recommendation

That the submissions be declined.

Issue: Exclude widely held and listed companies

Submission

(32 – KPMG)

To avoid favouring companies with a non-resident parent, the rule should exclude widely held companies and unit trusts or companies listed on the NZX. Stapled stock allows these companies to increase their debt ratios to the same extent as companies with a non-resident parent.

Comment

Most of New Zealand’s biggest companies are widely held (meaning, in general terms, that ownership and control is spread among a large number of investors). Their potential to increase their interest deductions is at the core of the base maintenance concerns arising from stapled stock.

Furthermore, the proposed new rule does not give companies with a non-resident parent any tax advantage that does not exist under the current law. As noted under the previous submission, any tax advantages that these companies enjoy are long-standing, not the result of the current proposal, and constrained by other tax rules.

Recommendation

That the submission be declined.

Issue: Exclude companies subject to thin capitalisation and other rules or with certain shareholder characteristics

Submissions

(32 – KPMG, 33 – Investment Savings and Insurance Association of NZ Inc, 36A – Russell McVeagh, 60 – Commonwealth Bank of Australia (New Zealand) Group, 62 – Minter Ellison Rudd Watts, 68 & 68A – Corporate Taxpayers Group)

Companies should not be subject to the new rule if they are (or opt to be) subject to the thin capitalisation rules, on the grounds that these rules provide adequate protection against excessive interest deductions. (KPMG, Commonwealth Bank of Australia, Minter Ellison Rudd Watts)

The transfer pricing rules, which apply to loans from non-resident controlling shareholders, also protect the tax base from excessive interest deductions. (Commonwealth Bank of Australia)

An exclusion from the stapled stock rule should be made where:

thin capitalisation rules are met;
the debt is subject to a market rate of interest; and
the debt is to be repaid at face value on maturity.

Such arrangements do not present an undue risk to the tax base. (Investment Savings and Insurance Association of NZ Inc)

Members of a New Zealand banking group should be excluded because the thin capitalisation rules for banks, which require a minimum level of equity, provide sufficient tax base protection in that industry. (Russell McVeagh)

Stapled stock is not an undue risk to the tax base if:

the issuing company is subject to or elects to be subject to the normal buttresses of the thin capitalisation and transfer pricing rules; or
the shareholders are all resident non-exempt taxpayers (or where the non-resident and exempt taxpayers hold less than, say, 10 percent of the shares on issue).

Excluding stapled stock from the rule in these cases would avoid discouraging foreign direct investment. Companies should be able to have as much debt as current rules allow using whatever instruments they believe provide the best commercial result. (Corporate Taxpayers Group)

Comment

The thin capitalisation and transfer pricing rules protect the tax base by limiting interest deductions.

The thin capitalisation rules cap the level of debt (usually at 75 percent of assets) on which a company can deduct interest. These rules apply to companies with a non-resident controlling shareholder, but will apply to more companies under proposed changes to the taxation of New Zealand companies’ direct investments abroad. The transfer pricing rules do not allow deductions of amounts paid to a non-resident related party above an “arms-length” price. This applies to interest just as it does to other expenses.

The assumption that the thin capitalisation and transfer pricing rules adequately protect against excessive interest deductions overlooks the key concern with this type of financial instrument. Stapled stock, being debt for tax purposes but equity for other purposes, allows companies to significantly increase their interest deductions, even within the scope of the thin capitalisation and transfer pricing rules. Stapled stock could also help companies to concentrate shareholder debt among the shareholders who can most benefit from it. Furthermore, treating stapled stock as debt when a company complies with thin capitalisation and transfer pricing rules, but as equity when it breaches those rules, could add substantial compliance and administration costs.

The Corporate Taxpayers Group’s submission that the stapled stock rule should not apply if all shareholders are resident, non-exempt taxpayers could also add compliance and administration costs. Listed companies would need to constantly gather information about their shareholders from share registrars and recharacterise their stapled stock accordingly. In addition, non-discrimination rules in New Zealand’s international tax treaties can limit the effect of tax rules based on shareholder residency.

Recommendation

That the submissions be declined.

Issue: Exclude if dividends on share are at fixed rate before conversion

Submission

(36A – Russell McVeagh, 60 – Commonwealth Bank of Australia (New Zealand) Group)

The submissions seek a wider exclusion for debts stapled only to shares of a certain type.

The submissions argue that the stapled stock rule should not apply if a debt is stapled only to a share that would be a fixed-rate share if only those dividends payable before conversion of the share were taken into account. Furthermore, they argue that this exclusion should ignore any dividend arising as a result of a formula, reflecting generally accepted market practice, for converting the share into another type of share.

According to the submissions, these changes are needed to achieve the intent of the current exclusion for debt stapled only to a fixed-rate share. They would help Australian banks with a New Zealand branch to comply with Australian bank regulations at minimum cost.

Comment

The current rule does not apply to debts stapled only to a “fixed-rate share”. This term is defined in the Income Tax Act, but has been widened for the purpose of this exclusion. In general it refers to a share that is similar to a debt because all dividends are at a fixed rate or have a fixed relationship to a recognised market interest rate.

Debt stapled only to a “fixed-rate share” is not equivalent to an ordinary share, because a fixed-rate share is a “debt substitute”, offering a return equivalent to an interest rate. Therefore, debt stapled only to a fixed-rate share is to be excluded from the stapled stock rule. However, the view expressed by submissions is that debt stapled to certain convertible preference shares that are similar to fixed-rate shares warrants the same exclusion.

A “convertible preference share” may or may not be a fixed-rate share. It typically offers a regular, fixed-rate dividend for a certain number of years, and then is exchanged for ordinary shares of a certain value (similar to paying back a debt). In some cases, the terms of a convertible preference share may change to those of an ordinary share (so the investor’s return depends on the value of ordinary shares, which depends on the company’s performance). Some conversions may combine both of these approaches (involving a change of terms and an issue of new shares up to a certain value).

The proposal suggested by submissions would mean that a debt stapled to a convertible preference share would not be subject to the stapled stock rule as long as all dividends paid before conversion are at a fixed rate, or have a fixed relationship to a recognised market rate of interest. However, potential gains (equity risk) at the point of conversion or later mean the share may not be a debt substitute, but more akin to an ordinary share. A debt stapled to such a share should not be excluded from the stapled stock rule. Therefore, officials do not recommend ignoring all potential gains on or after conversion.

In addition, because of the rarity and complexity of these arrangements, the resulting danger of admitting arrangements that mimic ordinary shares, and the availability of simpler arrangements that achieve the same broad commercial objective, we do not recommend attempting to define all situations where a convertible preference share is a debt substitute.

We do, however, recommend dealing with two specific reasons, highlighted by the submissions, why an essentially “fixed-rate” share might fail to meet the definition of a “fixed-rate share”. These variations typically arise when a preference share converts to a fixed value of ordinary shares (often including a small fixed premium on the amount originally invested). They do not add significant equity risk and should be ignored for the purposes of the exclusion.

The draft wording of the exclusion for debt stapled only to a fixed-rate share already allows for a dividend reflecting transaction costs expected to be incurred by the investor as a result of conversion of a preference share to an ordinary share. Typically such a dividend is provided by discounting the value of the ordinary share around three or four percent when calculating the number of new shares needed to match the value of the preference share. The purpose may not be specified. The rule should instead simply allow for any fixed gain on conversion of up to five percent of the amount subscribed for the share. This makes for simpler drafting and widens the exclusion.

In addition, the rate of conversion from one type of share to a fixed value of another type of share (equivalent to a fixed-value return of funds) depends on the estimated value of the other share. This value is typically estimated based on trades over the 20 trading days before conversion. An increase in the market value of the other share in the estimation period could result in the investor receiving a higher value of new shares than was intended. A potential small gain in value may take the share outside the usual fixed-rate share definition.

Recommendations

That stapled debt should be excluded from the rule if it is stapled only to a share that would be a “fixed-rate share” but for dividends arising from:

a fixed gain of no more than five percent of the amount subscribed for the share, upon conversion to another class of share; or
an increase in the price of another class of share during up to 30 days (allowing for a degree of flexibility) before conversion to the other class, of a number determined by the price observed in that period.

That, if this recommendation is agreed, the exclusion limited to discount factors used to compensate for expected transaction costs should be removed, because it will be redundant.

Issue: Amendments to thin capitalisation calculations

Submission

(32 – KPMG, 68A – Corporate Taxpayers Group)

Stapled debt should not be treated as debt for thin capitalisation purposes while treating it as equity for other tax purposes, as this would be inequitable.

The Corporate Taxpayers Group considered that implementing the rule would be complex, given the need to obtain shareholder residency information from share registrars each time a company undertakes a thin capitalisation calculation (although few companies are likely to issue stapled debt given the changes in the bill).

Comment

Under the new stapled stock rule, a stapled debt is to be treated as a share for most purposes. However, recharacterising stapled stock as a share for all tax purposes, regardless of the circumstances, could allow it to be used to circumvent the thin capitalisation rules. If a company is near the thin capitalisation limit on issuing debt, it could instead issue debt stapled to a small amount of equity and pay resident taxpayers, who benefit from imputation credits, fully imputed dividends at a post-tax rate of return. This would be economically equivalent to paying deductible interest.

For this reason, if stapled debt subject to the proposed rule is issued, it would usually be treated as debt for the limited purpose of the thin capitalisation rules. The exception would be if the debt was stapled proportionately to all shares in the company, and not concentrated in the hands of those who gain little tax advantage from holding debt.

Under the current drafting, the test to determine whether the debt is stapled proportionately to all shares in the company is applied at the time when the debt security is issued. The debt could easily cease to be stapled proportionately to shares, for example, as a result of the issue of new shares, or a de-stapling of some of the debt and shares. Officials consider that this test should instead be applied at the relevant time, which is when total group debt is measured under the thin capitalisation rules.

Recommendation

That the submission be declined, but that the test of whether debt is stapled in proportion to all shares in the company be applied when total group debt is measured under the thin capitalisation rules.

Issue: Deduction of expenditure incurred in borrowing

Submission

(32 – KPMG)

Under the proposal, a deduction would be denied for expenditure incurred in borrowing money secured by or payable under the stapled debt security. An amendment is needed to ensure that a deduction is only denied to the extent that borrowings are secured against the debt component of the stapled stock (as distinct from the share component).

Comment

The submission is in line with the draft legislation, and the draft legislation does not need to be amended to achieve this policy intent. As currently drafted, the proposed rule denies deductions in relation to a “stapled debt security”, being the debt component (referred to in this report as the “stapled debt”) of the overall stapled stock arrangement.

Recommendation

That the submission be declined.

Issue: Outbound stapled stock should be taxed at fair dividend rate (FDR)

Submission

(33 – Investment Savings and Insurance Association of NZ Inc)

When the rule applies to stapled stock issued to New Zealanders by offshore companies, the combined debt and equity returns of stapled stock should be taxed as one under the FDR method of taxing outbound portfolio investments. This would fairly reflect the economic position and limit the cost of having to identify, track and tax two separate instruments.

Comment

The stapled stock will not apply unless the interest would otherwise be deductible against New Zealand income. For the submission to be relevant, New Zealanders would have to own stapled stock issued by an offshore company, and the company would have to apply the funds raised by the stapled stock in a New Zealand branch of the company. This would be a relatively rare scenario. In any case, it is not within the scope of the current amendments to override the rules determining when the FDR method should be applied.

Recommendation

That the submission be declined.

Issue: Meaning of “stapled”

Submissions

(33 – Investment Savings and Insurance Association of NZ Inc, 35 – PricewaterhouseCoopers, 36B – Russell McVeagh, 68A – Corporate Taxpayers Group)

The term “stapled” is too broad and uncertain. As a result, it is unclear whether the following situations will be subject to the stapled stock rule:

when a shareholders’ agreement or an agreement of a similar nature implies but does not require that the debt and equity instruments be disposed of together;
when an investor who holds shares and debt within a business where the debt and equity are disposed of together, but were not required to be disposed of together;
when a financing arrangement, shareholders’ agreement or similar agreement outlines or assumes that equity and debt will be disposed of together but only in certain circumstances;
when, without the shareholder holding the debt, the shares would lose their value or vice versa. That is, there is not formal agreement that the debt and equity must be traded together but it is common practice, and an investor would not hold the shares without also having lent money to the entity. (Investment Savings and Insurance Association of NZ Inc, PricewaterhouseCoopers)

The provision should be limited to “stapling” requirements contained in the terms of the debt security, the share, or the constitution of the issuer. The issuer company must often be party to shareholders’ agreements for corporate law reasons. Applying the rule to such agreements would have significant unintended consequences. (Russell McVeagh)

It is unclear whether a company is “party” to a stapling arrangement simply because it is party to the debt and equity instruments themselves. (Corporate Taxpayers Group)

Comment

The submissions raise a concern that the proposed definition of “stapled” is too broad.

To fall within the proposed definition of “stapled”, an arrangement would need to meet two requirements.

The first requirement is that a debt security “can, or ordinarily can, be disposed of only together with the share”. This wording is used elsewhere in the Income Tax Act, and there is no history of dispute over its meaning. The words imply a requirement (albeit with possible exceptions), not a mere expectation or assumption or the possible exercise of a choice.

The second requirement is that a company that issued the debt security or the share must be a party to the stapling arrangement. This is intended to exclude conventional “shareholder agreements” that limit separate trading of debt and shares in smaller companies. These shareholder agreements were not the focus of the policy announcement in February 2008.

However, submissions have highlighted that many of these shareholder agreements have the relevant company as a party, and so would be subject to the stapled stock rule as currently drafted.

Widely held companies are not known for using shareholders’ agreements to bind debt and shares in the same way as closely held companies. To do so, they would most likely incur significant transaction costs. However, we cannot be certain that it will not occur.

To balance these concerns, officials recommend adopting the submitters’ proposal to include only those stapling arrangements made under the terms of the debt, the share, or the constitution of the issuer, but only for companies that are not widely held. A “widely held company” is defined in the Income Tax Act 2007 as one that has no less than 25 shareholders and is not a closely held company. A “closely held company” is, essentially, one controlled by five or fewer persons.

Recommendation

That, for companies that are not widely held, the stapled stock rule should only apply when the debt and share are stapled under the terms of the share, the debt, or the constitution of the company.

Issue: Debt securities offering no return or a conditional return

Submission

(35 – PricewaterhouseCoopers)

A debt security that ordinarily pays no interest, discount or premium to the holder, but is capable of doing so in certain circumstances, such as if interest is payable if demanded by the shareholders, should be excluded from the rule.

In some shareholder financing arrangements, it would be unclear whether a debt “…gives rise to an amount for which the company would have a deduction…” as required in the draft definition of a “debt security”. A positive exclusion for debt instruments that do not bear interest and are not issued for a discount or a premium would clarify the intent and remove uncertainty.

This circumstance may arise when a shareholder provides debt funding to a company in proportion to their shareholding, with a shareholder’s agreement and possibly a requirement in the company’s constitution that the debt and shares are not to be traded separately.

Comment

The definition of “a debt security” proposed in the draft legislation is based on the definition of “total group debt”, a term introduced in 1995 and used to determine a company’s debt ratio under the thin capitalisation rules. Officials are not aware of any dispute indicating that the meaning of this term is unclear.

Stapled debts offering no deductions are excluded from the proposed rule because they do not result in firms paying interest in substitution for dividends to reduce tax. In contrast, having interest payable if demanded by shareholders suggests a significant risk, with payments demanded in “good years” to distribute profits in a tax-effective way. It would not be appropriate to exclude such an arrangement from the stapled stock rule.

The more ambiguous arrangements referred to by PricewaterhouseCoopers are most likely to be found in agreements among shareholders of smaller companies. Under the previous submission point, on the meaning of the term “stapled”, officials recommended not including these shareholder agreements in the stapled stock rule.

Recommendation

That the submission be declined.

Issue: What happens when an existing debt becomes stapled or unstapled?

Submissions

(33 – Investment Savings and Insurance Association of NZ Inc, 35 – PricewaterhouseCoopers)

Greater clarity is needed on the effect of an existing debt becoming stapled or unstapled so that a debt that becomes unstapled is treated as a normal debt, with deductions available and the issuer able to repay in part or whole without stepping through the share repurchase rules. (Investment Savings and Insurance Association of NZ Inc, PricewaterhouseCoopers)

Transitional rules or guidance is needed to confirm how to reclassify as a share a stapled debt that the issuer has treated as debt, especially where this is retrospective. (PricewaterhouseCoopers)

Comment

Officials agree there is a need to clarify certain effects of the stapling of an existing debt to a share, or the de-stapling of a debt and a share.

The stapled stock rule only applies when a debt security is stapled to a share. If an existing debt security is stapled to a share, then thereafter it is treated as a share “issued by the company” if it falls within the stapled debt security rule. If a debt security is de-stapled, the rule no longer applies. The transitional tax effects of stapling and de-stapling are intended to flow accordingly. However, the submissions have drawn officials’ attention to two matters that need clarification.

First, it needs to be clarified that stapling of an existing debt is equivalent to a subscription for new shares, and a de-stapling after which the debt security ceases to be a share (rather than becoming a share under another provision) should be treated as a share cancellation. This will ensure that the appropriate adjustments are made to a company’s available subscribed capital, and an appropriate amount is treated as a dividend or, alternatively, treated as a return of capital upon de-stapling.

Secondly, the legislation should make it clearer that interest deductions are available if the stapled debt ceases to be treated as a share under the stapled stock rule.

With the narrow targeting of the rule, it is unlikely that any debts will need to be re-classified as a share retrospectively.

Recommendation

That stapling of an existing debt to a share should be treated as a subscription for shares, and that de-stapling be treated as a share cancellation with interest deductions subsequently available (unless other features of the arrangement, such as stapling to another share, cause the debt to continue to be treated as a share).

Issue: Exclusion – arrangements before 25 February 2008

Submissions

(33 – Investment Savings and Insurance Association of NZ Inc, 35 – PricewaterhouseCoopers)

Arrangements made before the announcement of the policy on 25 February 2008, and particularly ongoing employee share schemes, should be excluded from the new rule, even if stapling occurred later. Companies will face compliance and commercial issues if there are different tax treatments for stapled stock issued to employees as part of an ongoing programme before and after that date. (PricewaterhouseCoopers)

The Investment Savings and Insurance Association expressed the same concerns regarding ongoing unit trusts.

Comment

In theory, there would be practical problems for an employee share scheme or unit trust where debt was stapled both before and after 25 February 2008 as part of an on-going programme. However, continued issues of stapled stock under such schemes would raise the same policy concerns as other new issues of stapled stock.

Moreover, policy officials are not aware of any actual employee share scheme or unit trust that would be subject to the stapled stock rule. Some Australian unit trusts have issued stapled stock. To be affected, a non-resident unit trust would need to apply the funds raised in a New Zealand branch, which is very rare. If a specific example is identified, officials would consider whether any remedial action is required.

Recommendation

That the submissions be declined.

Issue: Date of application

Submission

(35 – PricewaterhouseCoopers)

Given the uncertainty around the legislation and when it will be enacted, the new rule should not apply until on or after the date it is enacted.

Comment

Inevitably, some uncertainty will exist around the legislation until it has been enacted. However, deferring application until enactment would leave in place a significant revenue risk until enactment, and create uncertainty around the date from which the new rule will apply.

Recommendation

That the submission be declined.

Issue: Unclear when stapled debt and share treated as one share

Submission

(35 – PricewaterhouseCoopers)

It is unclear from the current drafting whether a stapled debt security and share are intended to be one share for all purposes or only where the underlying share is a non-participating redeemable share. Therefore, section FA 2B(3) should be amended to read “a stapled debt security and a share to which it is stapled are treated as a single share where the underlying share to which the debt security is stapled falls within one of the following…”.

Comment

PricewaterhouseCoopers’ proposed wording would not be consistent with the policy intent.

The draft legislation treats the stapled debt as a separate share for nearly all purposes under the Act. However, when deciding whether the stapled debt or the share to which it is stapled meet certain definitions the two parts are to be considered together, in line with their economic substance.

This is consistent with the general approach of taxing debt and shares based on their legal form, with exceptions only when required to avoid undue risk to the tax base. The affected definitions identify shares that are “debt-like”. Stapled stock could be used to defeat the purpose of the definitions if both parts were not taken into account.

Recommendation

That the submission be declined.

Issue: Treating stapled debt and share as one share means no share cancellation

Submission

(68A – Corporate Taxpayers Group)

Treating the share and stapled debt as one share when applying the definition of a “non-participating redeemable share” means that redemptions of stapled debt will be inappropriately treated as a taxable dividend if the debt is redeemed. If the two parts are treated as one share, the redemption cannot be a share cancellation.

Comment

Under the proposed rule, the stapled debt and share would be treated as one share when testing whether either part is a non-participating redeemable share. However, when applying the remainder of the tax rule governing share cancellations, the two parts remain separate shares that can be separately cancelled.

The definition of a “non-participating redeemable share” is found in the off-market share cancellation rule, which determines how much of an amount paid on cancellation of a share is treated as a tax-free return of capital, and how much is treated as a dividend. It is unlikely that a stapled debt will ever be a non-participating redeemable share, but its redemption may be treated partly or wholly as a non-taxable return of capital under another test.

Recommendation

That the submission be declined.

Issue: Section reference in proposed stapled stock amendments

Submission

(32 – KPMG)

In clause 542B, the reference should be changed to section FA 2B(2).

Comment

The clause amends the Income Tax Act 2004, and refers correctly to proposed section FC 2B of that Act, set out in clause 578D of the draft legislation.

Recommendation

That the submission be declined.

Issue: Definition of a “fixed-rate share”

Submission

(35 – PricewaterhouseCoopers)

The definition of a “fixed-rate share” in the stapled securities rule should clarify the weight to be put on each of the three indicators that a dividend is “the equivalent of the payment of interest on money lent”.

Comment

While there may be value in considering this matter in the future, it is outside the scope of the stapled stock proposal. The “fixed-rate share” definition to be used to exclude certain arrangements from the stapled stock rule combines and expands two existing fixed-rate share definitions. The meaning of the “equivalent of interest” wording has not led to any notable dispute, and changing it could have wider implications.

Recommendation

That the submission be declined.

Issue: Should exclude hybrid instruments

Submission

(35 – PricewaterhouseCoopers)

The legislation should exclude debt-equity hybrid instruments such as convertible notes, unless they are stapled to another security. Such instruments are generally treated for tax purposes as part debt and part equity. These parts can only be disposed of together.

Comment

No amendment is needed to achieve the intent of the submission. The stapled stock rule will only apply if an apparently separate debt and share must be traded together. It would not apply to a convertible note unless it is stapled to another security (a share).

Recommendation

That the submission be declined, noting that the draft legislation already achieves the submission’s policy intent.

Issue: Definition of “stapled”

Submission

(Matter raised by officials)

Paragraph (b) of the proposed definition of “stapled” should be amended by inserting the words “the company that issued” after the words “the company that issued the debt security or”. This will more clearly allow for the possibility that different companies are involved.

Recommendation

That the submission be accepted.

Issue: Definition of “non-participating redeemable preference share”

Submission

(Matter raised by officials)

There is a possible circularity in the proposed treatment of cancellations of stapled debts treated as shares. Therefore, we propose that a stapled debt and share should not be aggregated when applying subparagraph (b)(iii) of the definition of a non-participating redeemable share in section CD 22(9) of the Income Tax Act 2007, or its predecessor in the Income Tax Act 2004.

Recommendation

That the submission be accepted.