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Ruling
Subject: Application of Division 974 and Division 230 of the Income Tax Assessment Act
Question 1
In regards to the Redeemable Preference Shares (RPS) and Ordinary Shares (OS) on issue by Co A will the proposed amendments to the terms of the RPS result in a material change for the purposes of subsection 974-110(1) of the ITAA 1997?
Answer
No
Question 2
Will the proposed amendments to the terms of the RPS on issue by Co A result in a material change to RPS or OS for the purposes of subsection 974-110(2) of the ITAA 1997?
Answer
No
Question 3
Will any of the conditions for a balancing adjustment set out in subsection 230-435(1) of the ITAA 1997 be satisfied in relation to the proposed amendments to the RPS?
Answer
No
Question 4
Will the proposed amendments to the RPS constitute a material change under section 230-185 of the ITAA 1997 (therefore requiring a fresh assessment of the treatment of gains and losses under the accruals or realisation method under subsection 230-185(1) of the ITAA 1997)?
Answer
Yes
Relevant facts and circumstances
1. Co A is an Australian resident company.
2. Co A has on issue an equivalent paid up amount of OS and RPS.
3. The OS give rise to an equity interest in Co A for the purposes of paragraph 974-70(1)(a) of the ITAA 1997.
4. The RPS give rise to a debt interests in accordance with subsection 974-15(1) of the ITAA 1997.
5. Co A has proposed to amend the terms of the RPS.
Relevant legislative provisions
Income Tax Assessment Act 1997 section 974-110(1)
Income Tax Assessment Act 1997 subsection 974-110(2)
Income Tax Assessment Act 1997 subsection 230-185(1)
Income Tax Assessment Act 1997 subsection 230-435(1)
Reasons for decision
Question 1
Section 974-110 of the ITAA 1997 contains rules which ensure that the general requirement under Division 974 of the ITAA 1997 that the debt and equity tests are applied to schemes at the time the scheme comes into existence does not prevent Division 974 applying where the scheme has changed in a material way.
In particular subsection 974-110(1) of ITAA 1997 provides that if:
(a) a *scheme or schemes give rise to a *debt interest (or an *equity interest) in a company; and
(b) the scheme, or one or more of the schemes, are subsequently changed, including where one or more (but not all) of the schemes cease to exist; and
(c) the scheme or schemes as they exist immediately after the change would give rise to an equity interest (or a debt interest) in the company if they came into existence when the change occurred; and
(d) subsection (1A) does not apply to the change;
this Division applies after the change as if the scheme or schemes as they exist immediately after the change came into existence when the change occurred.
The effect of section 974-110 of the ITAA 1997 is to put an imperative on the issuer to retest the interest under Division 974 of the ITAA 1997 every time there is a change to an existing scheme to ensure it is not a material change that changes its classification under Division 974 from debt to equity or vice versa.
With respect to the OS, the OS will continue to be characterised as equity for tax as no changes are proposed to its terms and conditions thereby not invoking section 974-110 of the ITAA 1997.
With respect to the RPS, the interest will need to be retested under Division 974 of the ITAA 1997 to determine whether the proposed changes to the RPS effects a material change which reclassifies from debt to equity.
The RPS, as it will exist immediately after the proposed change, will be deemed to have come into existence when the change occurs to determine if it gives rise to a debt or equity interest: see 974-110(1)(c ) of the ITAA 1997. That is, the debt and equity tests are applied at time of the proposed change.
The debt test is contained in subsection 974-20(1) of the ITAA 1997 as follow:
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
(d) 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
(e) 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).
Based on the facts provided, as all the requirements of the debt test have been satisfied in relation to the RPS at time of the proposed change, the RPS will give rise to a debt interest in Co A under subsection 974-15(1) of the ITAA 1997. Consequently, there is no effect of material change under section 974-110 of the ITAA 1997.
Accordingly, the RPS will continue to be characterised as debt for tax purposes.
Question 2
Detailed reasoning
Subsection 974-110(2) provides that if:
(a) a *scheme or schemes give rise to a *debt interest (or an *equity interest) in a company; and
(b) the company subsequently enters into, participates in or causes another entity to enter into or participate in a new *related scheme; and
(c) the scheme or schemes, together with:
(i) the new related scheme; and
(ii) any other related scheme that the entity (or company) enters into, participates in or causes another entity to enter into or participate in before the new related scheme is entered into;
would give rise to an equity interest (or a debt interest) in the company if they all came into existence when the new related scheme is entered into;
this Division applies after the new related scheme is entered into as if all the schemes referred to in paragraph (c) had come into existence when the new related scheme is entered into.
Based on the facts provided, the proposed changes to the terms and conditions of the RPS do not result in a new related scheme for the purposes of paragraph 974-110(2)(b) of the ITAA 1997 and therefore will not result in a material change to the RPS or OS for the purposes of subsection 974-110(2) of the ITAA 1997. Accordingly, subsection 974-110(2) of the ITAA 1997 will not apply to reclassify the RPS or OS.
Question 3
Broadly, a balancing adjustment is an additional amount of gain or loss brought to account if one of the events in subsection 230-435(1) of the ITAA 1997 happens, to ensure the correct amount of gain or loss is brought to account from holding and disposing of the financial arrangement.
Subsection 230-435(1) of the ITAA 1997 specifies when balancing adjustment is made. Subsection 230-435(1) provides:
A balancing adjustment is made under this Subdivision if:
(a) you transfer to another entity all of your rights and/or obligations under a *financial arrangement; or
(b) all of your rights and/or obligations under a financial arrangement otherwise cease; or
(c) you transfer to another entity:
(i) a proportionate share of all of your rights and/or obligations under a financial arrangement; or
(ii) a right or obligation that you have under a financial arrangement to a specifically identified *financial benefit; or
(iii) a proportionate share of a right or obligation that you have under a financial arrangement to a specifically identified financial benefit; or
(d) an *arrangement that is a *Division 230 financial arrangement ceases to be a financial arrangement.
Based on the facts provided, the conditions for a balancing adjustment set out in subsection 230-435(1) of the ITAA 1997 will not be satisfied in relation to the proposed amendments to the RPS, therefore, section 230-435 of the ITAA 1997 does not apply in this case and there is no requirement to make a balancing adjustment under Subdivision 230-G of the ITAA 1997.
Question 4
Where there is a material change to the terms, conditions or circumstances of a financial arrangement, a fresh assessment will need to be made as to whether the accruals or realisation methods will apply to a gain or loss from that arrangement (subsection 230-185(1) of the ITAA 1997).
It should be noted that it is possible for both the compounding accruals method and the realisation method to apply to gains or losses arising from a single financial arrangement. This may occur because some of the financial benefits under the financial arrangement are sufficiently certain and others are not (Explanatory Memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (the EM) at paragraph 4.41).
Whether a change is a material change depends on the facts and circumstances of the relevant arrangement (paragraph 4.224 of the EM).
Subsection 230-185(2) of the ITAA 1997 provides examples of material changes to the terms, condition or circumstances of a financial arrangement. Based on the facts provided, it is considered that amending the terms of the RPS constitute a material change to the terms of the arrangement.
Regardless of whether gains or losses from the RPS are subject to the realisation or accruals method prior to the amendment of the terms, where material changes are made a fresh assessment of the applicability of either the realisation or accruals methods to gains or losses from the RPS is required pursuant to section 230-185 of the ITAA 1997.
As the proposed amendments to the RPS will constitute a material change under section 230-185 of the ITAA 1997 a fresh assessment of the treatment of gains and losses in relation to the RPS will be required under subsection 230-185(1) of the ITAA 1997.
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