Edited version of your private ruling

Authorisation Number: 1012516997969

Ruling

Subject: Capitalisation of interest on a non-share equity interest

Question

For the purposes of section 12-210 of Schedule 1 to the Taxation Administration Act 1953 (TAA), has the entity paid a dividend to a non-resident where interest is capitalised in a manner set out in a condition of the deed?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2011.

Year ended 30 June 2012.

Year ended 30 June 2013.

Year ending 30 June 2014.

Year ending 30 June 2015.

Relevant facts

1. The entity is an Australian resident company.

2. The entity issued convertible notes to foreign resident entities.

3. The convertible notes are governed by a deed and subscription agreement.

4. Under the deed conditions, interest is accrued at accrual dates and added to the face value of the convertible notes.

5. For accounting purposes, the convertible notes are treated in accordance with the principles in Australian Accounting Standards Board AASB 132 - Financial Instrument: Presentation. To the extent that a convertible note can only be settled by the issue of ordinary shares, the instrument is recognised as equity for accounting purposes. The financial liability (debt) component of the convertible note is measured at the present value of the interest payable on the note until it is converted, discounted at the market rate of the interest for a similar instrument with a similar credit status that has no conversion option.

6. The accounting entry on issue of the convertible notes was:

Dr Cash XX

Cr Liability XX

Cr Equity XX

7. For accounting purposes, the interest that accrues on the convertible notes is required to be recognised over the term of the note. In this respect, the interest is recognised against the liability amount recognised on issue of each convertible note.

8. Interest that has accrued on each convertible note is capitalised on the accrual date, and there is an increase in the face value of each convertible note.

9. For accounting purposes this increase in the face value is split between a financial liability and equity for accounting purposes in a similar manner to the original issue of the convertible notes.

10. Under the convertible note conditions, the interest that accrues is never due and payable.

11. The convertible notes are non-share equity interests for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 974-115

Income Tax Assessment Act 1997 section 974-120

Income Tax Assessment Act 1997 subsection 995-1(1)

Taxation Administration Act 1953 subsection 3AA(2)

Taxation Administration Act 1953 section 12-20 of Schedule 1

Taxation Administration Act 1953 section 12-210 of Schedule 1

Taxation Administration Act 1953 section 12-300 of Schedule 1

Reasons for decision

The convertible notes are non-share equity interests for the purposes of Division 974 of the ITAA 1997. Under section 12-20 of Schedule 1 to the TAA, Division 12 and the regulations relating to Division 12 of Schedule 1 to the TAA applies to:

(a) non-share equity interests in the same way as it applies to a share;

(b) an equity holder in the same way that it applies to a shareholder; and

(c) a non-share dividend in the same way that it applies to a dividend.

If a dividend is paid by an Australian resident to an entity that has an address outside of Australia, then section 12-210 of Schedule 1 to the TAA may apply:

A company that is an Australian resident must withhold an amount from a *dividend it pays if:

(a) according to the register of company's members, the entity, or any of the entities, holding the *shares on which the dividend is paid has an address outside Australia; or

(b) the entity, or any of those entities, has authorised or directed the company to pay the dividend to an entity or entities at a place outside Australia.

However, under section 12-300 of Schedule 1 to the TAA, an entity is not required to withhold an amount from a dividend:

(a) if no withholding tax is payable in respect of the dividend, or

(b) more than the withholding tax payable in respect of the dividend (reduced by each amount already withheld).

Note: the liability for withholding tax on a dividend for a foreign resident shareholder arises under subsection 128B(1) of the Income Tax Assessment Act 1936 (ITAA 1936).

The entity is an Australian resident company and the convertible noteholders consists of foreign resident entities that have addresses outside of Australia. Accordingly, if the entity pays a 'dividend' to the convertible noteholders, it must withhold amounts from those dividend payments under section 12-210 of Schedule 1 to the TAA (unless there is no withholding tax liability (for example, if the dividend is franked)).

The issue arises as to whether the entity has paid a 'dividend' in circumstances where interest on the convertible notes is capitalised on accrual dates where that interest is added to the face value of the convertible notes.

As non-share dividends are treated in the same way as dividends under paragraph 12-20(c) of Schedule 1 to the TAA, it must be determined whether the capitalisation of interest on an accrual date constitutes the distribution of a non-share dividend.

The term 'non-share dividend' is defined in section 974-120 of the ITAA 1997 (through the operation of subsection 3AA(2) of the TAA and the definition of 'non-share dividend' in subsection 995-1(1) of the ITAA 1997) to mean all non-share distributions except to the extent to which the distribution is debited against the company's non-share capital account or the company's share capital account.

Note that the exclusions in the definition do not apply in this instance as there is no debit entry to the entity's non-share capital account or share capital account.

The term 'non-share distribution' is defined in section 974-115 of the ITAA 1997 to mean:

A company makes a non-share distribution to you if:

(a) you hold a *non-share equity interest in the company; and

(b) the company:

(i) distributes money to you; or

(ii) distributes other property to you; or

(iii) credits an amount to you;

as the holder of that interest.

The convertible notes are non-share equity interests in the entity (being equity interests in the entity that are not solely a share - refer to the definition of 'non-share equity interest' in subsection 995-1(1) of the ITAA 1997). Accordingly, paragraph 974-115(a) of the ITAA 1997 is satisfied.

The entity has not distributed money to the convertible noteholders by capitalising the interest on the convertible notes. Accordingly, subparagraph 974-115(b)(i) of the ITAA 1997 is not satisfied.

Consequently, the issue then becomes whether the capitalisation of interest on the convertible notes is the distribution of other property to the convertible noteholders or whether the capitalisation of interest is an amount that is 'credited' by the entity to its convertible noteholders (that is, whether either subparagraphs 974-115(b)(ii) or 974-115(b)(iii) of the ITAA 1997 are satisfied).

In Permanent Trustee Co of New South Wales Ltd v. Commissioner of Taxation (1940) 64 CLR 663; (1940) 6 ATD 5; [1940] ALR 291, the deceased taxpayer was entitled to receive a principal sum plus interest, which was capitalised by a deed executed by the debtor and delivered to the taxpayer. The High Court unanimously held that although 'the interest was by the deed carried to the capital account, and in this sense capitalised,' no income was derived by the taxpayer, who 'got nothing except a new obligation to pay in exchange for an existing obligation to pay [and] was no nearer getting his money or of transferring it into anything of any value'. Starke J stated:

… despite the covenant, which on the face of it looks as if the parties had received the sums and had re-invested or capitalised them at interest, the true facts were, although that was the form of the transaction, that it was not the substance nor the truth of the transaction, and that all the mortgagee did was to take a further security for moneys that were owing to him. The essence of the matter is that there was no actually realised or realisable income. In receiving the further charge the mortgagee did not thereby receive payment or the equivalent of payment of the sums assessed. What happened was that the mortgagee received a security for an existing debt. To give security for a debt is not to pay a debt.

In Jolly v. Federal Commissioner of Taxation (1933) 50 CLR 131; (1933) 2 ATD 434; [1934] ALR 86; [1934] HCA 66 (Jolly's Case) Dixon J said of the reference to dividends credited or paid to a member that 'the description was satisfied if the shareholder received a specific sum of money in currency or obtained the benefit of such a sum by way of credit entry, set off or other statement of account'.

In Brookton Co-operative Society Ltd v. Federal Commissioner of Taxation (1981) 147 CLR 441; (1981) 11 ATR 880; 81 ATC 4346 the directors of a company were empowered to pay interim dividends but not to declare dividends They resolved to pay an interim dividend but before payment, rescinded the resolution and made no payment. The Commissioner argued that within the definition in subsection 6(1) of the ITAA 1936, the dividend had nevertheless been 'paid', in that it had been credited in the accounts of both payer and payee. This contention was rejected. Mason J stated:

Payment of a dividend may occur in a variety of ways not involving payment in cash or by bill of exchange, as, for example, by an agreed set-off, account stated or an agreement which acknowledges that the amount of the dividend is to be lent by the shareholder to the company and is to be repaid to the shareholder in accordance with the terms of that agreement. It is, however, well settled that the making of a mere entry in the books of a company without the assent of the shareholder does not establish a payment to the shareholder (Manzi & Ors v Smith & Anor (1975) 49 ALJR 376 at 377.

Mason J went on to hold that in law there had been no payment of the dividend. In addressing the argument that the dividend had been sufficiently 'credited' that it was deemed to be paid, his Honour observed that a dividend declared by the company, creating a debt due to the member (in Re Severn and Wye and Severn Bridge Railway Company, [1896] 1 Ch. 559), was for the purposes of the Act neither paid nor assessable until the debt was discharged, and concluded that 'it would be irrational and incongruous to give ['paid'] a more radical application when applied to an interim dividend', where there was no debt created in favour of the member, much less any discharge of a debt. Despite the credit entries nothing passed from the company to the member, neither cash nor property nor any new entitlement.

For the entity, under the convertible note deed no interest is due and payable on the accrual date, and despite the credit entries for accounting purposes, nothing passes from the entity to the convertible noteholders.

However where, for example, a company declares a dividend and the shareholder acquires in satisfaction of the entitlement a different right, then the outcome may be different (Re Harry Simpson (1966) 84 WN (Pt 1) (NSW) 455 and Re Rural & Veterinary Requisites Pty Ltd (in liq.) (1977-1978) CLC 30,182 (40459)).

In Lonsdale Sand and Metal Pty Ltd v. Federal Commissioner of Taxation (1998) 81 FCR 419; (1998) 38 ATR 384; 98 ATC 4175 (Lonsdale's Case) Mansfield J concluded that entries in its records writing off a debt due to the company by an associate of a shareholder, which under a complex arrangement for sale of some of the capital of the company were agreed to effect an extinguishment of the debt, amounted to a 'crediting' of an amount 'for the individual benefit of [the] associated person' so as to be deemed to be a dividend out of profits by section 108 of the ITAA 1936.

After referring to Webb v. Federal Commissioner of Taxation (1922) 30 CLR 450; (1922) R and McG 33; (1922) 28 ALR 284 and Jolly's Case, and also to James v. Federal Commissioner of Taxation (1924) 34 CLR 404; (1924) R and McG 53; (1924) 30 ALR 293 and Commissioner of Taxes (Vict.) v. Nicholas (1938) 59 CLR 230; (1938) 4 ATD 484; [1938] ALR 192; [1938] HCA 18 (in each of which the amount to which bonus shares were paid up was said to have been 'credited' by the company to the member), and to the payment effected when the amount of a dividend is set off against a debt due by the member to the company, his Honour concluded that:

… at the least, there must be something in the nature of an allocation or appropriation of the company's resources to an individual shareholder or to the shareholders each individually [A] forgiveness of debt will be caught, in my view, if the crediting of an amount against a shareholder's (or associate's) loan account is recorded in the books of the company and in substance constitutes an appropriation of the profits of the company for the benefit of the shareholder (or associate).

Although the concept of 'credited' is widely expressed in his Honour's judgment ('to enter upon the credit side of an account; give credit for or to; to give the benefit of such an entry'), the reasoning to the conclusion shows that a mere book entry is not enough: there must (for 'crediting' in the context of section 108 of the ITAA 1936) be an 'in substance' distribution of assets to the member.

The composite transaction in Lonsdale's Case resulted not merely in a book entry 'writing off' the associate's debt, but in the release at law of the debt: in substance, the transfer of the debt to the associate, in a manner binding on the company. (The decision was on this ground distinguished in Ashton Mining Ltd v. Federal Commissioner of Taxation [2000] FCA 590; 2000 ATC 4307; (2000) 44 ATR 249).

Unlike the situation in Lonsdale's Case, in the present context there is no debt due by the convertible noteholders to the entity that is set off. Rather, the entry in the entity's ledger merely records the current balance of the obligation assumed at the issue of the convertible notes, to pay the principal sum plus compound interest.

While an entry recording the obligation to pay in the ledgers of the debtor is a credit entry, it does not amount to 'crediting' the amount entered to the creditor for the purposes of the provisions of the Income Tax Assessment Acts dealing with payment of dividends or non share distributions. More is required than a mere journal or ledger entry. An entry recording an obligation to pay is not payment (c.f. Manzi v. Smith (1975) 132 CLR 671; (1975) 7 ALR 685; [1975] HCA 35 and Temples Wholesale Flower Supplies Pty Ltd v. Commissioner of Taxation (1991) 29 FCR 93; (1991) 21 ATR 1606; 91 ATC 4387).

In the present context the increase in the face value of the convertible notes does not result in any property of the entity passing to the convertible noteholders, nor in the vesting in them of any new entitlement.

The amounts that the entity has promised to pay to the convertible noteholders are recorded in a ledger of the entity at its cumulative balance (with the face value of the convertible notes increased by the interest accrued at each accrual date). The changing of the face value of the convertible notes is simply a mechanism to reflect a change in the face value upon which the interest will be calculated at the next accrual date.

The convertible note conditions make no provision for any step which affects any discharge of the obligation to pay the accruing interest before maturity of the convertible notes. All that occurs is that the accrued liability is recognised by the entity for accounting purposes. No amount of 'interest' is actually due and payable by the entity while the interest is capitalised under the deed.

Therefore, the capitalisation of interest on the convertible notes does not amount to a 'crediting' by the entity to the convertible noteholders as shareholders (equity holders).

Consequently, as there is no distribution of other property or the 'crediting' of an amount to the convertible noteholders, the capitalisation of the interest on the convertible notes does not satisfy either subparagraphs 974-115(b)(ii) or 974-115(b)(iii) of the ITAA 1997.

Accordingly, as capitalisation of the interest on the convertible notes is not a non-share distribution as defined (and is therefore not a non-share dividend as defined), an amount is not required to be withheld by the entity under section 12-210 of Schedule 1 to the TAA in relation interest that is capitalised in a manner set out in a condition of the convertible note deed.

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