ATO Interpretative Decision

ATO ID 2004/883

Income Tax

• This document incorporates revisions made since original publication. View its history and amending notices, if applicable.

Issue

What is the characterisation of a priority partnership interest in a corporate limited partnership under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) which has the characteristics stated in the facts below and where the related schemes provisions in section 974-70 of the ITAA 1997 have no application to the scheme?

Decision

The priority partnership interest will give rise to a debt interest as it satisfies the test for a debt interest under section 974-20 of the ITAA 1997.

Facts

In order to raise finance, a corporate limited partnership issues to its limited partner a priority partnership interest (PPI) with the following terms:

•

face value of $1,000,000

•

any return to be paid on the PPI will be at the discretion of the General Partner of the Limited Partnership

•

the PPI will pay a priority distribution of profit to its holder. This priority distribution of profit will be at a rate agreed to by the partners but this rate will be no higher than 150 basis points above the benchmark rate of return as defined in section 974-145 of the ITAA 1997

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the limited partnership must repay in cash the full amount of capital contributed by the Limited Partner for the PPI, (referred to as priority capital), 6 years from the date of its issue, and

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if the partnership is dissolved prior to the repayment date of the PPI the capital contributed for the PPI must be repaid to the Limited Partner in full before any loans made by a partner and related interest and capital of the partnership are repaid to the partners.

Reasons for Decision

In order to determine whether the PPI are debt interests, the debt test under section 974-20 of the ITAA 1997 requires examination as considered below:

(a) Whether the scheme is a financing arrangement for the entity.

As the partnership is a corporate limited partnership for the purposes of Division 5A of the Income Tax Assessment Act 1936 (ITAA 1936), for income tax purposes the partnership is treated as a company pursuant to section 94J of the ITAA 1936 and the partnership interest, being a membership interest is an interest covered by item 1 of the table in subsection 975-75(1) of the ITAA 1997

As such, the scheme does not need to satisfy paragraph 974-20(1)(a) of the debt test, and so it is unnecessary to consider whether the scheme is a financing arrangement for the entity.

(b) Whether the entity, or connected entity of the entity, receives or will receive a financial benefit or benefits under the scheme.

The partnership has received $1,000,000 in return for issuing the PPI to the Limited Partner. This is a financial benefit as paragraph 974-160(1)(a) of the ITAA 1997 states that a financial benefit includes 'anything of economic value'.

(c) Whether the entity has, or the entity or the connected entity of the entity each has, an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when:

i.

the financial benefit referred to in paragraph (b) is received if there is only one; or

ii.

the first of the financial benefits referred to in paragraph (b) is received if there are more than one.

An 'effectively non-contingent obligation' is defined in section 995-1 of the ITAA 1997 to have the meaning given by section 974-135 of the ITAA 1997. Subsection 974-135(1) of the ITAA 1997 provides inter alia that:

There is an effectively non-contingent obligation to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action.

Under the terms of the PPI the partnership may at the discretion of the General Partner pay to the Limited Partner annually a priority distribution of profit on the PPI at a rate per annum agreed from time to time by the partners provided the rate is no higher than 150 basis points above the benchmark rate of return as defined in section 974-145 of the ITAA 1997. As these payments are contingent on the existence of profits and the General Partner exercising its discretion to distribute any such profits there is not, in substance or effect, an effectively non-contingent obligation on the Partnership to pay a priority distribution.

However, the terms of the PPI provide that the partnership must repay the priority capital in full to the Limited Partner 6 years from the date of its issue unless the partnership is dissolved earlier, in which case the proceeds of the partnership property shall be applied in repayment of the priority capital to the Limited Partner in full before any loans made by a partner and related interest and capital of the partnership are repaid to the partners. The Partnership is thus under an effectively non-contingent obligation to return the face value of the priority capital to the Limited Partner.

In addition to the requirement of an effectively non-contingent obligation, there is also requirement that the entity provide a financial benefit. Paragraph 974-20(1)(c) of the ITAA 1997 is satisfied because the repayment of the priority capital to the Limited Partner at the end of the term must be for cash and thus subsection 974-30(1) of the ITAA 1997 will not apply.

(d) Whether it is substantially more likely than not that the benefit provided will at least equal the value received.

Paragraph 974-35(1)(a) of the ITAA 1997 provides that the value of a financial benefit to be provided or received is to be calculated in nominal terms if the performance period ends no later than 10 years after the interest arising from the scheme is issued or, in present value terms if the performance period must, or may, end more than 10 years after the interest arising from the scheme is issued. In this instance, the PPI has a performance period of less than 10 years so the financial benefits must be valued in nominal terms.

Only those financial benefits that are effectively non-contingent are taken into account for valuation purposes (refer subsection 974-20(4) of the ITAA 1997).

Valuing the effectively non-contingent financial benefits received and provided under the scheme in nominal terms has the result that it is substantially more likely than not that the value of the financial benefits provided ($1,000,000) will at least equal to the value of the financial benefits received ($1,000,000) and accordingly this requirement is satisfied.

(e) Whether both the value provided and the value received are not both nil.

As discussed in (d) above the values provided and received are not both nil and accordingly this requirement is satisfied.

Therefore, all the requirements of the debt test have been satisfied, and as such the PPI will be a debt interest for taxation purposes in accordance with Division 974 of the ITAA 1997. Although items 1, 2 and 3 of the equity interest table in subsection 974-75(1) of the ITAA 1997 will also be satisfied, paragraph 974-70(1)(b) of the ITAA 1997 provides that an interest can not be characterised as an equity interest if it is also characterised as a debt interest.

Year of income:  Year ended 30 June 2005

Legislative References:
Income Tax Assessment Act 1936
   section 94P
   section 94Q

Keywords
Debt equity borderline
Debt test
Limited partnerships

Siebel/TDMS Reference Number:  3878675

Business Line:  Finance and Investment Centre of Expertise

Date of publication:  12 November 2004

ISSN: 1445-2782