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Ruling

Subject: Debt/Equity Interests

Question 1

Do the Convertible Notes constitute a debt interest under Subdivision 974-B of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The Convertible Notes will be characterised as equity interests under Division 974 of the ITAA 1997.

This ruling applies for the following periods:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

A company was seeking to raise capital for the purpose of expanding the operations of the business and also to return capital to existing shareholders. The capital raising took the form of 2 Tranches of Convertible Notes, issued to the investor.

Convertible Notes - Quantity and Issue Price

Two Tranches of convertible notes issued to the investor:

· Tranche 1 comprised of a note or notes with a principal amount, convertible to shares at a stated issue price.

· Tranche 2 comprised of a note or notes with a maximum principal amount which would convert to shares at a stated issue price.

Tranche 1 funds are to be used by the company to finance capital investment and working capital. Tranche 2 funds were used by the company for a Buy Back Offer.

The investor paid for Tranche 1 and Tranche 2 on the completion date, at which time the company issued the notes and the board resolved to appoint the investor representatives.

The investor will have the right to participate in any future issue of securities by the company in order to maintain its prorate ownership of the company (on a converted basis).

Maturity

The convertible notes have a maturity of 5 years, if not converted earlier, at which time they will be redeemed and discharged, with interest payable.

Conversion into shares

On allotment and issue, the Conversion Shares will be fully paid and unencumbered, free from any charge and registered in the name of the investor.

Interest, redemption and conversion conditions

The convertible notes carry interest of a set rate per annum on the principal amount, payable at maturity, except where the investor opts to convert within 3 years of issue, or the audited EBITDA of the company reaches a predetermined amount in the 12 months ending 30 June 2012 or within 2 years from date of issue which will result in automatic conversion.

Dividends

The investor will be entitled to any dividend or distribution paid by the company during the 3 years after date of issue, however these amounts will be deducted against any interest that may be payable in respect of the Convertible Notes during the 3 years after the date of issue.

Status and rights of Notes

Each note is an unsecured obligation of the company and will rank pari passu and rateably without any preference among themselves and at least pari passu with all present and future direct, unsubordinated, unconditional and unsecured obligations of the company, save for such obligations as may be preferred by provisions of law that are both mandatory and of general application.

Voting

The convertible notes do not carry voting rights prior to conversion.

Relevant legislative provisions

Division 974 ITAA 1997

Subdivision 974-B ITAA 1997

Subdivision 974-C UTAA 1997

Section 974-5 ITAA 1997

Section 974-15 ITAA 1997

Section 974-20 ITAA 1997

Section 974-35 ITAA 1997

Section 974-75 ITAA 1997

Section 974-130 ITAA 1997

Section 974-135 ITAA 1997

Section 974-160 ITAA 1997

Subsection 995-1(1) ITAA 1997

Reasons for decision

Division 974 of the ITAA 1997 holds the legislative provisions used to determine whether an interest is a debt interest or equity interest for tax purposes.

Subsection 974-5(1) explains that the test for distinguishing between debt interests and equity interests focuses on economic substance rather than mere legal form.

Subsection 974-5(4) provides that if an interest satisfies both the debt test and the equity test, it will be treated as a debt interest.

Debt Test:

Subsection 974-15(1) of the ITAA 1997 provides that:

A scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) in relation to the entity.

The word 'scheme' is broadly defined in subsection 995-1(1) of the ITAA 1997 as:

(a) any arrangement; or

(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

In this arrangement, a resolution was passed relating to the Convertible Note issue, an Agreement has been entered into regarding the Convertible Notes issue, and a Convertible Note Deed has been signed. Therefore, there is a scheme for the purposes of these provisions.

Subsection 974-20(1) of the ITAA 1997 requires the following conditions to be satisfied before a scheme can be said to give rise to a debt interest in an entity:

A scheme satisfies the debt test in this subsection in relation to an entity if:

(a) the scheme is a financing arrangement for the entity; and

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

(c) the entity has, or the entity and a 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; and

(a) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and

(b) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil.

The scheme does not need to satisfy paragraph (a) if the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) (interest as a member or stockholder of the company).

The requirements of the debt test in relation to the Convertible Notes arrangement are discussed below.

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

Section 974-130 of the ITAA 1997 defines the term 'financing arrangement'. Under paragraph 974-130(1)(a) a financing arrangement includes a scheme entered into or undertaken:

(a) to raise finance for the entity (or a connected entity of the entity);

In this instance, the scheme has been entered into in order to fund the expansion and share buy-back of the company and thus falls within the definition of 'financing arrangement'.

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

Subsection 974-160(1) of the ITAA 1997 defines 'financial benefit' to mean:

(a) anything of economic value; and

(b) includes property and services; …

When identifying any financial benefits, they are to be looked at separately and not set off against each other in determining whether there is a financial benefit for this purpose (see subsection 974-160(2) of the ITAA 1997).

The financial benefits identified under this arrangement include the following:

· the principal amounts paid on the issue of the Convertible Notes.

Under this scheme, the company has issued Convertible Notes which are expected to be converted into shares with a stated issue price, or repaid with interest. In return the investor has made Tranche payments to the company of the principal amounts. The tranche payments so received are a 'financial benefit' received.

This element of the debt test is satisfied.

(c) the entity has, or the entity and a 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 relevant time when the financial benefit is received.

In order to satisfy paragraph 974-20(1)(c), the company must have an 'effectively non-contingent obligation' under the scheme to provide a financial benefit to one or more entities.

'Effectively non-contingent obligation' is defined in section 974-135 of the ITAA 1997.

Subsection 974-135(1) of the ITAA 1997 states:

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.

Subsection 974-135(3) of the ITAA 1997 states:

an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation.'

Under the current scheme, there are two formal contingencies in the Convertible Note Deed, being that:

(a) the principal amounts will not be repaid if the investor elects to convert the Convertible Notes into shares; and

(b) conversion of the notes into shares will occur if an audited LTM EBITDA of the issuer reaches a predetermined amount for the period ended 30 June 2012 or within 2 years of date of issue, in which case neither the principal or any interest will be payable by the company.

However, the investor option to convert the Convertible Notes into shares, does not by itself make the company's obligation to repay the investment not non-contingent, due to subsection 974-135(4).

Subsection 974-135(4) states:

the existence of the right of the holder of an interest that will or may convert into an equity interest in a company to convert the interest does not of itself make the issuer's obligation to repay the investment not non-contingent.

The obligation of the company to repay the principal amounts on the Convertible Notes is contingent on the company not meeting the target annual audited EBITDA of a predetermined amount within the specified timeframe as set out in the Convertible Note Deed. As such, the obligation is formally contingent. Consideration must then be given to whether the obligation is effectively non-contingent as per subsection 974-135(3).

Taxation Ruling TR 2008/3 considers the tests for debt/equity under Division 974 of the ITAA 1997, where the issuer has the right to convert convertible notes into equity. Whilst the scheme facts ruled on in TR 2008/3 is not relevant to this scheme, the ruling does examine the term 'effectively non-contingent' in the context of subsection 974-135(3). Paragraphs 37 and 38 of TR 2008/3 state:

37. The reason for having an effectively non-contingent test rather than simply a formal contingency test is further explained at paragraph 2.178 of the EM as follows:

2.178 … In this regard, reliance solely on a formal non-contingent test would enable taxpayers to easily impose artificial contingencies in order to prevent an interest being debt. In addition, consistent with the principle inherent in the debt test of focusing on economic substance rather than legal form, where a contingency is so remote as to be effectively inoperative (immaterially remote) it is as if the contingency did not exist and it should be disregarded.

38. Therefore, where the provision of a financial benefit on an instrument is formally subject to a contingency, that formal contingency may be disregarded if, upon consideration of the pricing, terms and conditions of issue of an instrument, the substance or effect fo the arrangement is that the financial benefit will be provided by the issuer, despite the formal contingency. Artificial or contrived contingencies may be disregarded (subsection 974-135(6)). A contingency that is immaterially remote, as explained above, will be disregarded.

Consideration must therefore be given whether the contingency where the Convertible Notes will be converted to shares if the target annual audited EBITDA is met, is either artificial, contrived or immaterially remote.

The company has advised that the formal contingencies relating to the EBITDA or the investor's option to convert within 3 years of issue, are not artificial, contrived or immaterially remote. The company's expectation is that the Convertible Notes will convert to equity within two years from the date of issue of the Convertible Notes. This is affirmed in the company's Private Ruling application which states:

The enterprise is undertaking the buy-back on the presumption that triggers for converting the convertible Notes from a debt instrument to an equity holding will be met within 12 months of the buy-back arrangement. Therefore, on the basis that the profit targets will trigger the conversion of the convertible notes into an equity interest, the company is issuing new capital to buy back existing capital.

Based on the above information, the company does not have an 'effectively non-contingent obligation' to repay the principal amounts obtained under the Convertible Notes and therefore does not satisfy the debt test under section 974-20 of the ITAA 1997 (specifically paragraph 974-20(1)(c)).

It should be noted that, since the 'effectively non-contingent obligation' condition in paragraph 974-20(1)(c) is not met, the 'substantially more likely than not' condition in paragraph 974-20(1)(d) and the 'values not nil' condition in paragraph 974-20(1)(e) do not need to be considered.

Equity Test:

Subdivision 974-C of the ITAA 1997provides a test for determining when an interest is an equity interest in a company.

A scheme gives rise to an equity interest in a company if, when the scheme comes into existence, it satisfies the equity test in subsection 974-75(1) of the ITAA 1997 in relation to the company because of the existence of an interest and the interest is not characterised as, and does not form part of a larger interest that is characterised as, a debt interest under Subdivision 974-B (see subsection 974-70(1)).

Based on the above analysis, the Convertible Notes issued by the company does not constitute a debt interest under Subdivision 974-B.

The Convertible Notes satisfy Items 2, 3 and 4 of the equity table in subsection 974-75(1) of the ITAA 1997 and therefore constitutes an equity interest under Subdivision 974-C.

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