The 2001 Debt and Equity Tax Rules: Evidence of Non-Tax Neutrality in Australia

Abstract

Tax arbitrage was extensive within the convertible market in Australia. The Treasury sought ways to minimize the tax misclassification issue and in 2001, the Commonwealth enacted the New Business Tax System (Debt and Equity) Bill 2001. This paper investigates whether the new tax rules classify convertibles in accordance to their economic substance rather than their legal form. The findings suggest evidence of stability and consistency within the convertible market post 2001. However, the economic substance of a security depends on the stock price at conversion/maturity. Hence, allocating a tax classification at issuance raises doubts on whether the security can be appropriately classified in accordance to its economic substance. The findings suggest that the non-financial cohort within the equity-like category are non-tax neutral. This category is highly unlikely to convert to common stock, similar to fixed-income securities.