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Ruling

Subject: Capital raising - Issuance of non-share equity

Question 1

Are the Notes non-share equity interests under the definition contained in section 995-1 of the Income Tax Assessment Act 1997 ('the ITAA 1997')?

Answer

Yes, the Notes will be non-share equity interests under the definition contained in section 995-1 of the ITAA 1997.

Question 2

Are the Notes traditional securities for the purposes of sections 26BB and 70B of the Income Tax Assessment Act 1936 ('the ITAA 1936')?

Answer

No, the Notes will not be traditional securities for the purposes of sections 26BB and 70B of the ITAA 1936.

Question 3

Will any Redemption Distribution be a non-share dividend pursuant to section 974-120 of the ITAA 1997?

Answer

Yes, any Redemption Distribution will be a non-share dividend pursuant to section 974-120 of the ITAA 1997.

Question 4

Will any Redemption Distribution and any Note Distribution be a frankable distribution under subsection 202-40(2) of the ITAA 1997 and therefore be capable of being franked in accordance with section 202-5 of the ITAA 1997?

Answer

Yes, any Redemption Distribution and any Note Distribution will be a frankable distribution under subsection 202-40(2) of the ITAA 1997 and therefore capable of being franked in accordance with section 202-5 of the ITAA 1997.

Question 5

Will the Commissioner seek to make a determination under paragraph 204-30(3)(a) of the ITAA 1997 to deem a franking debit to arise as a result of any imputation benefits attaching to franked Note Distributions?

Answer

No, the Commissioner will not seek to make a determination under paragraph 204-30(3)(a) of the ITAA 1997 to deem a franking debit to arise as a result of any imputation benefits attaching to franked Note Distributions.

Question 6

Will the Commissioner seek to apply paragraph 177EA(5)(a) of the ITAA 1936 to deem a franking debit to arise as a result of any imputation benefits attaching to franked Note Distributions?

Answer

No, the Commissioner will not seek to apply paragraph 177EA(5)(a) of the ITAA 1936 to deem a franking debit to arise as a result of any imputation benefits attaching to franked Note Distributions.

Relevant facts and circumstances

Company X is an unlisted public company which is an Australian resident under subsection 6(1) of the ITAA 1936.

Company X is proposing to issue certain Notes in order to raise capital.

Company X will credit the proceeds from the issue of the Notes to a non-share capital account. On redemption of the Notes, Company X will debit this non-share capital account up to the amount credited to that account on subscription for the Notes.

Under the terms of the Notes, franked distributions are intended to be paid on the Notes annually over the life of the Notes and at redemption (representing any amounts in excess of the amount debited to Company X's non-share capital account). Under the terms of the Notes, all distributions (including the amounts debited to Company X's non-share capital account at redemption) will be contingent on the economic performance of Company X at the relevant distribution times.

It is intended that Company X will have sufficient availability of frankable profits immediately before the payment of Note distributions annually over the life of the Notes or at redemption of the Notes.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 section 26BB

Income Tax Assessment Act 1936 section 26C

Income Tax Assessment Act 1936 section 70B

Income Tax Assessment Act 1936 section 128B

Income Tax Assessment Act 1936 subsection 159GP(1)

Income Tax Assessment Act 1936 subsection 177A(1)

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 section 177EA

Income Tax Assessment Act 1936 section 318

Income Tax Assessment Act 1997 section 36-55

Income Tax Assessment Act 1997 section 164-10

Income Tax Assessment Act 1997 section 164-20

Income Tax Assessment Act 1997 section 202-5

Income Tax Assessment Act 1997 section 202-15

Income Tax Assessment Act 1997 section 202-20

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 section 204-30

Income Tax Assessment Act 1997 section 207-45

Income Tax Assessment Act 1997 section 215-10

Income Tax Assessment Act 1997 section 215-15

Income Tax Assessment Act 1997 section 215-20

Income Tax Assessment Act 1997 section 960-115

Income Tax Assessment Act 1997 section 974-15

Income Tax Assessment Act 1997 section 974-20

Income Tax Assessment Act 1997 section 974-70

Income Tax Assessment Act 1997 section 974-75

Income Tax Assessment Act 1997 section 974-115

Income Tax Assessment Act 1997 section 974-120

Income Tax Assessment Act 1997 section 974-130

Income Tax Assessment Act 1997 section 974-135

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

The Notes will be non-share equity interests under the definition contained in section 995-1 of the ITAA 1997.

Detailed reasoning

Subsection 995-1(1) of the ITAA 1997 defines a non-share equity interest in a company as an equity interest that is not solely a share.

Subsection 995-1(1) of the ITAA 1997 provides that an equity interest in a company has the meaning given by Subdivision 974-C of the ITAA 1997.

Equity Interest

Subsection 974-70(1) of the ITAA 1997 provides that a scheme satisfies the equity test if the scheme gives rise to any of the interests in list in the table therein. The issue of the Notes satisfies item 2 of the table because:

the returns on the Notes are contingent on the economic performance of Company X.

Subsection 974-75(2) of the ITAA 1997 further provides that a scheme that would otherwise give rise to an equity interest in a company because of an item in the table in subsection 974-75(1) of the ITAA 1997 (other than item 1) does not give rise to an equity in the company unless the scheme is a financing arrangement for the company.

The term 'financing arrangement' is defined in section 974-130 of the ITAA 1997. It generally refers to a scheme entered into by an entity to raise finance for itself or a connected entity. From the facts presented to the Commissioner, the proposed issuance of the Notes is being undertaken by Company X to raise capital and will therefore constitute a financing arrangement.

Debt Test

Paragraph 974-70(1)(b) of the ITAA 1997 provides a scheme gives rise to an equity interest in a company if, when the scheme comes into existence, the interest is not characterised as, and does not form part of a larger interest that is characterised as a debt interest in the company or a connected entity of the company under Subdivision 974-B of the ITAA 1997.

The requirements for satisfying the debt test are contained in subsection 974-(20)(1) of the ITAA 1997. As neither Company X nor any of its connected entities have an effectively non-contingent obligation to provide a financial benefit under the scheme, the issuance of the Notes does not satisfy the requirements of paragraph 974-20(1)(c) of the ITAA 1997.

As the debt test will not be satisfied the characterisation of the Notes will remain an equity interest as defined under section 974-70 of the ITAA 1997. The consequence of which is the Notes will be considered to be non-share equity interests pursuant to subsection 995-1(1) of the ITAA 1997.

Question 2

Summary

The Notes will not be traditional securities for the purposes of sections 26BB and 70B of the ITAA 1936.

Detailed reasoning

To qualify as a traditional security, subsection 26BB(1) of the ITAA 1936 specifies that a security must:

· be acquired after 10 May 1989;

· not have an eligible return, or where it does have an eligible return, the precise amount of the eligible return is able to be ascertained at the time of issue of the security and it must not exceed 1.5% of payments multiplied by the number of years in the security;

· not be a prescribed security within the meaning of section 26C of the ITAA 1936; and

· not be trading stock of the taxpayer.

For the purposes of section 26BB of the ITAA 1936, a 'security' has the meaning given by subsection 159GP(1) of the ITAA 1936 to mean:

(a) stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;

(b) a deposit with a bank or other financial institution;

(c) a secured or unsecured loan; or

(d) any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured.

From the facts presented to the Commissioner, the Notes will not be caught by either paragraphs 159GP(1)(b) or (c) of the ITAA 1936.

The Notes would also not be considered to be stock, bonds, debentures, certificates of entitlement, bills of exchange or promissory notes for the purposes of paragraph 159GP(1)(a) of the ITAA 1936.

The term 'or other security' which concludes paragraph 159GP(1)(a) of the ITAA 1936 is not defined within the Income Tax Acts.

Taxation Ruling TR 96/14 Income Tax: traditional securities ('TR 96/14'), sets-out the Commissioner's view of various interpretive matters relating to sections 26BB and 70B of the ITAA 1936 and traditional securities. One of the matters addressed in TR 96/14 is the Commissioner's view as to the meaning of the term 'other security'.

The Commissioner states at paragraph 24 of TR 96/14:

The Explanatory Memorandum which accompanied Division 16E doesn't comment on the use of the term 'or other security' but states (at 13):

'Paragraph (a) of the definition refers to items that are usually taken to be a security.'

The ruling goes on to discuss relevant case law on the issue of what constitutes a security, with the Commissioner concluding at paragraph 29 of TR 96/14:

… it is our view that the term 'or other security' in the context in which it is used only encompasses instruments that evidence an obligation on the part of the issuer or drawer to pay an amount to the holder or acceptor, whether during the term of the instrument or at its maturity.

(Emphasis added)

Based on the guidance provided by the Commissioner in paragraph 29 of TR 96/14, the Notes would not be considered to be caught by the term 'or other security', as any obligation on the part of Company X as issuer to pay an amount during the life of the Note or at redemption, is contingent on the economic performance of Company X.

The Commissioner provides the following view on the scope of paragraph 159GP(1)(d) of the ITAA 1936 at paragraph 30 of TR 96/14. Here he states:

While paragraph (a) of the definition specifies items that are more easily recognisable as securities, paragraph (d) includes contracts under which there is a liability to pay an amount. The apparent breadth of that definition is moderated for the purposes of Division 16E by other threshold provisions, and most contracts that ostensibly fall within the definition are taken outside its operation by these mechanisms. The traditional securities' provisions do not contain similarly explicit provisions to filter out many contracts which fall within the broad scope of the definition. On the face of the definition, all contracts which evidence a liability to pay any amount may be securities, subject to the limited exclusions in subsection 26BB(1). However, having regard to the discussions at paragraphs 22, 28 and 29 of this Ruling, and paragraphs (a), (b) and (c) of the definition of 'security' in subsection 159GP(1) only those contracts that have debt like obligations will usually fall under paragraph (d) of the definition of 'security'.

(Emphasis added)

For the same reasons discussed in relation to the application of paragraph 159GP(1)(a) of the ITAA 1936, the Notes will not be caught within the ambit of paragraph159GP(1)(d) of the ITAA 1936 as a 'security', as the obligations to pay any amount under the Notes are contingent on the economic performance of Company X and do not exhibit debt like obligations.

Accordingly, the Notes will not satisfy the definition of 'traditional security' for the purposes of sections 26BB and 70B of the ITAA 1936.

Question 3

Summary

Any Note distributions paid annually to Note holders over the life of the Notes or at the redemption of the Notes will be non-share dividends pursuant to section 974-120 of the ITAA 1997.

Detailed reasoning

As the Note holders will have a non-share equity interest in Company X, section 974-115 of the ITAA 1997 provides that distributions on the Notes will constitute non-share distributions.

Pursuant to section 974-120 of the ITAA 1997 all non-share distributions will be 'non-share dividends' except to the extent they are debited against Company X's non-share capital account or share capital account.

From the facts presented to the Commissioner, any Note distributions made annually over the life of the Notes will not be debited to Company X's non-share capital account or capital account.

As these distributions will not be debited against Company X's non-share capital account or share capital account, they will be considered non-share dividends pursuant to subsection 974-120(2) of the ITAA 1997.

Section 164-10 of the ITAA 1997 establishes that Company X will be considered to have a non-share capital account when it issues the Notes and section 164-15 of the ITAA 1997 requires Company X to credit its non-share capital account with the subscription proceeds from the issuance of each Note.

Upon redemption of the Notes, subsections 164-20(1) and (2) of the ITAA 1997 prescribe that Company X may debit its non-share capital account up to the amount credited to the account in respect of the Notes.

Any additional amount not debited to Company X's non-share capital account or share capital account will be a non-share dividend pursuant to subsection 974-120(2) of the ITAA 1997.

Question 4

Summary

Any Note distribution paid annually to Note holders over the life of the Notes or at the redemption of the Notes will be a frankable distribution under subsection 202-40(2) of the ITAA 1997 and will therefore be capable of being franked in accordance with section 202-5 of the ITAA 1997.

Detailed reasoning

Section 202-5 of the ITAA 1997 outlines that an entity will be taken to have franked a distribution where the following conditions are satisfied:

(a) the entity is a franking entity that satisfies the residency requirement when the distribution is made; and

(b) the distribution is a frankable distribution; and

(c) the entity allocates a franking credit to the distribution.

The term 'franking entity' is defined pursuant to section 202-15 of the ITAA 1997, and specifically includes a 'corporate tax entity'. The term 'corporate tax entity' is itself defined pursuant to section 960-115 of the ITAA 1997 to include companies.

The 'residency requirement' stipulated in paragraph 202-5(a) of the ITAA 1997 is set-out in section 202-20 of the ITAA 1997. Insofar as it applies to a company, it prescribes that that the company must be an Australian resident when making a distribution.

From the facts presented to the Commissioner, Company X will be both a corporate tax entity and an Australian resident at all relevant times, and will satisfy the requirements of paragraph 202-5(a) of the ITAA 1997.

The term 'frankable distribution' is defined pursuant to section 202-40 of the ITAA 1997. It provides that a non-share dividend is a frankable distribution, to the extent that it is not unfrankable under section 202-45 of the ITAA 1997.

Any Note distribution paid annually over the life of a Note or at redemption of a Note will not be sourced from either Company X's non-share capital account or its capital account, and will therefore be a non-share dividend.

A distribution will be unfrankable if it falls within any of the circumstances listed in section 202-45 of the ITAA 1997. There is no specific circumstance listed within section 202-45 of the ITAA 1997 which states that a non-share dividend of the type to be paid on the Notes either annually over the life of the Notes or at redemption of the Notes would otherwise be an unfrankable dividend.

However, paragraph 202-45(f) of the ITAA 1997 provides that a distribution will be unfrankable if section 215-15 of the ITAA 1997 applies. Section 215-15 of the ITAA 1997 will apply where, broadly speaking, an issuer has insufficient availability of frankable profits immediately before the time of payment of a non-share divided.

From the facts presented to the Commissioner, it is intended that Company X will have sufficient availability of frankable profits immediately before the payment of Note distributions annually over the life of the Notes or at redemption of the Notes.

Therefore, any Note distribution paid annually to Note holders over the life of the Notes or at the redemption of the Notes will be a frankable distribution under subsection 202-40(2) of the ITAA 1997 and will satisfy the requirements of paragraph 202-5(b) of the ITAA 1997.

Provided Company X allocates franking credits to any Note distribution paid annually to Note holders over the life of the Notes or at the redemption of the Notes (pursuant to paragraph 202-5(c) of the ITAA 1997), such distributions will be capable of being franked.

Question 5

Summary

The Commissioner will not seek to make a determination under paragraph 204-30(3)(a) of the ITAA 1997 to deem a franking debit to arise as a result of any imputation benefits attaching to franked Note distributions paid annually over the life of the Notes or at redemption of the Notes.

Detailed reasoning

Subdivision 204-D of the ITAA 1997 enables the Commissioner to make a determination to either impose a franking debit or deny an imputation benefit where distributions with imputation benefits are streamed to a member of a corporate tax entity in preference to another member.

Section 204-30 of the ITAA 1997 prescribes the circumstances that are required to exist before the Commissioner may make such a determination. Section 204-30 of the ITAA 1997 applies where an entity 'streams' the payment of distributions in such a way that:

· an 'imputation benefit' is or apart from section 204-30 of the ITAA 1997 would be, received by a member of the entity as a result of the distribution or distributions (paragraph 204-30(1)(a) of the ITAA 1997);

· the member (favoured member) would derive a greater benefit from franking credits than another member of the entity (paragraph204-30(1)(b) of the ITAA 1997); and

· the other member (disadvantaged member) of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits (paragraph 204-30(1)(c) of the ITAA 1997).

From the facts presented to the Commissioner, any Note distributions made annually over the life of the Notes or at redemption of the Notes are expected to be fully franked. As such, the Note holders will receive an imputation benefit as a result of such Note distributions. This is on the basis that any Australian resident Note holder should receive the benefit of a tax offset (as set-out in paragraph 204-30(6)(a) of the ITAA 1997) or receive a franking credit to their franking account as a result of a Note distribution (as set-out in paragraph 204-30(6)(c) of the ITAA 1997). Any non-resident Note holders should receive an imputation benefit in the form of an exemption from dividend withholding tax (as set-out in paragraph 204-30(6)(e) of the ITAA 1997).

The term 'streams' is not defined for the purposes of the Income Tax Acts. However, the concept of 'streaming' is described in paragraph 3.28 of the Explanatory Memorandum to the New Business Tax System (Imputation) Act 2002 ('the EM') as:

… selectively directing the flow of franked distributions to those members who can most benefit from imputation credits.

Paragraphs 3.29 and 3.30 of the EM go on to stipulate:

3.29 The law uses an essentially objective test for streaming, although purpose may be relevant where future conduct is a relevant consideration. It will normally be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of members on the basis of their ability to use franking benefits is a key element of streaming.

3.30 Thus, streaming is unlikely to occur when a corporate tax entity, in making franked distributions, distinguishes between 2 classes of members, both of which comprise members who can and who cannot benefit from imputation credits. However, where one class is predominately able to use imputation credits, and the other is predominately not, it may be apparent that an arrangement is streaming, notwithstanding the presence in each class of small minority of the other type of member.

Whether or not a streaming arrangement has been implemented requires an objective determination to be made of whether the arrangement involves the selective directing of franked distributions to those members who can most benefit from franking credits to the exclusion of others. Section 204-30 of the ITAA 1997 is intended to be sufficiently broad in its scope and may apply to any strategy directed at defeating the policy of the law by avoiding wastage of franking credits through such arrangements.

From the facts presented to the Commissioner, it cannot be concluded that 'streaming' exists in relation to any franked Note distributions to be paid by Company X to Note holders. Accordingly, the Commissioner will not seek to make a determination under paragraph 204-30(3)(a) of the ITAA 1997 to deem a franking debit to arise a result of any imputation benefits attaching to any franked Note distributions made annually over the life of the Note or the Note or at redemption of the Note.

Question 6

Summary

The Commissioner will not seek to apply paragraph 177EA(5)(a) of the ITAA 1936 to deem a franking debit to arise as a result of any imputation benefits attaching to any franked Note distributions made annually over the life of the Note or at the redemption of the Note.

Detailed reasoning

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies where one of the purposes (other than an incidental purpose) of a scheme is to enable a relevant taxpayer to obtain an imputation benefit. Where this purpose exists, paragraph 177EA(5)(a) of the ITAA 1936 empowers the Commissioner to make a determination that franking debits or exempting debits will arise in the franking account of a corporate tax entity that is the distributing entity and a party to the scheme.

Pursuant to subsection 177EA(3) of the ITAA 1936, the provision applies if the following conditions are satisfied:

a) there is a scheme for the disposition of membership interests, or an interest in the membership interests, in a corporate tax entity; and

b) either:

i. a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

ii. a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in the membership interests, as the case may be; and

c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

d) except for section 177EA of the ITAA 1936, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

e) having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

The term 'scheme for the disposition' as used in paragraph 177EA(3)(a) of the ITAA 1936 is defined pursuant to subsection 177EA(14) of the ITAA 1936. The term is defined quite broadly and includes the issuing of membership interest or creating an interest in a membership interest (paragraph 177EA(14)(a) of the ITAA 1936).

It is noted that paragraph 177EA(3)(a) of the ITAA 1936 refers to a disposition of a membership interest in a 'corporate tax entity'. Pursuant to section 960-115 of the ITAA 1997, a 'corporate tax entity' includes a company.

Further, subsection 177EA(12) of the ITAA 1936 stipulates that section 177EA of the ITAA 1997 applies to non-share equity interests in the same way as it applies to membership interests, members and distributions.

The Notes will constitute non-share equity interests in Company X. Therefore, for the purposes of applying section 177EA of the ITAA 1936 the issuance of the Notes by Company X will constitute a disposition of a membership interest, thus satisfying the requirements of being a scheme of disposition for the purposes of subsection 177EA(14) of the ITAA 1936.

From the facts presented to the Commissioner, the conditions established in paragraphs 177EA(3)(b) to (d) of the ITAA 1936 will also be satisfied.

Accordingly, the issue is whether, having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme, did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

Circumstances which are relevant in determining whether any person had the requisite purpose include, but are not limited to, the factors listed in subsection 177EA(17) of the ITAA 1936. The relevant circumstances, taken individually or collectively, could indicate the requisite purpose. Due to the wide range of these circumstances, some may or may not be present at one time in any one scheme.

Having regard to the relevant objective circumstances of the scheme listed in subsection 177EA(17) of the ITAA 1936, the Commissioner considers that on balance, in the particular circumstances of this case, the purpose of enabling a relevant taxpayer to obtain an imputation benefit is not considered to be more than incidental to other purposes of the scheme.

Therefore, the Commissioner will not make a determination under paragraph 177EA(5)(a) of the ITAA 1936 in respect of any franked Note distributions made over the life of the Notes or at the redemption of the Notes.

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