The following example illustrates the application of the debt and equity test to the issue of converting preference shares.
Example: Converting preference shares
A bank issues converting preference shares on 1 July 2011 at an issue price of $100 each. The shares pay annual dividends of 7.5%. Conversion is mandatory on 30 June 2016.
End of exampleTest steps
The following steps determines if it is an equity interest or a debt interest.
Equity test step 1: is the interest an equity interest?
As the interest is in the form of a share, it is an equity interest unless it is a debt interest.
Debt test step 1: is there a scheme?
There is a scheme in the form of an arrangement between the bank and the holder.
Debt test step 2: is the scheme a financing arrangement?
The contract in respect of converting preference shares is an arrangement entered into to raise finance for the bank.
Debt test step 3: does the issuing entity receive a financial benefit under the arrangement?
The bank receives a financial benefit under the arrangement. The value of the benefit received is the $100 issue price.
Debt test step 4: does the issuing entity have an effectively non-contingent obligation to provide a financial benefit?
The bank doesn't have an effectively non-contingent obligation to provide a future financial benefit because the payment of dividends is contingent on the profit of the bank and the value of the shares on conversion is disregarded. This condition is not satisfied. The interest is not treated as a debt interest. Accordingly, the interest is an equity interest.