15 Apr 08 Interest held to be on capital account - St GeorgeThe Federal Court (Allsop J) has held that interest paid by the taxpayer to a Delaware incorporated subsidiary (LLC), pursuant to its obligations under a subordinated debenture, was not deductible, being an outgoing of capital or of a capital nature for the purposes of s 8-1(2)(a) of ITAA 1997.
LLC was established and capitalised to US$107.2 million by share subscription of common stock of LLC by two wholly-owned Australian subsidiaries of the taxpayer. LLC also issued US$250 million preference stock in the US market. Although issued in the US debt market, such stock was a form of preference share and sums payable on it were dividends. LLC then lent US$350 million to the taxpayer under an indenture, and a debenture was issued by taxpayer to LLC. The consequence of the arrangements was that the Reserve Bank of Australia was satisfied that the taxpayer satisfied the minimum ratio of qualifying capital to risk-weighted assets, both on a consolidated basis, and on a stand-alone basis.
Allsop J held that the interest outgoings were outgoings of capital or of a capital nature for the purposes of s 8-1(2)(a) of the 1997 Act. This was so because, in short, the advantage sought and obtained by them, assessed in the whole context of the capital raising, was not the use by the borrower of the money during the term of the loan, but the maintenance and support of the capital raised by LLC. At para 76, his Honour said:
"The advantage sought and obtained by the payment of interest under the Debenture was the maintenance of the loan as an integral part of the establishment and maintenance of a structural strengthening of the capital base of SGB [the taxpayer] and the SGB Group. The advantage was the underpinning and continuation of the capital raising and its funding by paying dividends through the integral and integrated mechanism of the loan from the special purpose vehicle which was a conduit, LLC. The advantage sought from the periodic payment of interest was one that accrued to SGB itself – the maintenance of the expansion and strengthening of its and its group’s capital standing as an aspect of the structure of its business and the satisfaction of the RBA of capital adequacy ratios as a condition of its banking licence. It would be misleading and inadequate to describe the advantage calculated to be effected by the payment of interest as the temporary maintenance of a loan providing funds for SGB. The advantage sought was the maintenance and continuation of the overall addition to the enhancement of SGB’s and the group’s capital structure by funding LLC for the sole purpose of paying dividends to the extent LLC was not prohibited from doing so."
St George Bank Limited v FCT  FCA 453 (Federal Court, Allsop J, 11 April 2008).
For a copy of the decision, go here