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Edited version of your private ruling
Authorisation Number: 1012534089224
Ruling
Subject: Private Binding Ruling: Debt/Equity Rules - Related Entities
Question 1
Will the proposed redeemable preference shares (Proposed RPS) to be issued by the taxpayer's subsidiary and the ordinary shares in the taxpayer on issue to the investors constitute related schemes for the purposes of section 974-155 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
Yes
Question 2
If the ordinary shares issued by the taxpayer and the Proposed RPS to be issued by the taxpayer's subsidiary are related schemes for the purposes of section 974-155 of the ITAA 1997, will the ordinary shares and Proposed RPS together give rise to a single notional debt interest in the taxpayer pursuant to subsection 974-15(2) of the ITAA 1997?
Answer
Yes
Question 3
If it is considered that the ordinary shares and Proposed RPS will together give rise to a single notional debt interest in the taxpayer under subsection 974-15(2) of the ITAA 1997, will the Commissioner make a determination under subsection 974-15(4) of the ITAA 1997 that it would be unreasonable to treat the schemes as related schemes giving rise to a single notional debt interest in the taxpayer under subsection 974-15(2) of the ITAA 1997?
Answer
Yes
Question 4
Will the Proposed RPS to be issued by the taxpayer's subsidiary be characterised as a debt interest in accordance with section 974-15 of the ITAA 1997?
Answer
Yes
Question 5
Will the ordinary shares on issue by the taxpayer be characterised as an equity interest in accordance with section 974-70 of the ITAA 1997?
Answer
Yes
This ruling applies for the following periods:
Dd/mm/yyyy to dd/mm/yyyy
The scheme commences on:
The scheme has commenced
Relevant facts and circumstances
1. By application dated dd/mm/yyyy, the taxpayer lodged a request for a Private Binding Ruling (the Ruling) in relation to certain tax implications of a proposed issuance of Redeemable Preference Shares (Proposed RPS) to be undertaken by the taxpayer.
2. The Scheme to which this Ruling applies has been ascertained from the following documents:
(i) Application for the Ruling dated dd/mm/yyyy (Application);
(ii) Constitution of the taxpayer (Constitution 1);
(iii) Constitution of a subsidiary of the taxpayer (Constitution 2);
(iv) Subordination Deed Poll (RPS) (Existing RPS SDP); and
(v) Draft RPS Subscription Agreement (Proposed RPS Subscription Agreement).
3. The taxpayer is an Australian resident public company.
The taxpayer currently has X shareholders.
4. All shareholders in the taxpayer are arm's length parties with respect to each other and the taxpayer. No individual shareholder can control the taxpayer and the taxpayer cannot control the objectives or actions of any shareholder.
5. The taxpayer has Y wholly-owned subsidiaries.
6. The taxpayer elected to form a tax consolidated group with its wholly-owned subsidiaries. As such, the taxpayer and its wholly owned subsidiaries are treated as a single entity for income tax purposes.
7. The capital structure of the taxpayer is currently comprised of:
· ordinary shares issued by the taxpayer; and
· Redeemable Preference Shares issued by the taxpayer's subsidiary (Existing RPS).
8. Each Existing RPS in the taxpayer's subsidiary is stapled to an ordinary share in the taxpayer.
9. An ASIC company search verified the taxpayer controls the relevant subsidiary.
10. The current corporate and ownership structure of the taxpayer has been omitted.
11. The ordinary shares and Existing RPS issued by the taxpayer and its subsidiary are ultimately used to fund the taxpayer's investments.
12. The terms and conditions associated with the issue of ordinary shares in the taxpayer are governed by Constitution 1 and include such terms and conditions which are normally associated with ordinary shares including:
· The right to receive dividends;
· The right to participate in surplus capital on winding up;
· The right to vote at any meeting of shareholders on the basis of one vote per share; and
· The right to appoint Directors.
13. A relevant clause of Constitution 1 specifies that the Directors have the power to declare dividends on ordinary shares and that dividends shall not be paid except out of profit of the company and does not bear interest as against the company.
14. The terms of issue for the Existing RPS in the taxpayer's subsidiary are governed by its Constitution and the RPS Subscription Agreement. The key terms of the Existing RPS are summarised below:
Terms |
Detail |
Issue Date |
200X financial year |
Mandatory Redemption Date |
20XX financial year |
Face Value |
omitted |
Redemption Value |
$1 greater than face value |
Coupon Rate |
omitted |
Dividend Entitlement |
The holder of the Existing RPS is entitled to a non-cumulative dividend. The payment of the dividend is subject to · There being funds legally available for the payment of dividends; and · interest payment received in respect of Notes issued |
Stapled Security |
· Each Existing RPS is stapled to an ordinary share. · RPS cannot be issued to a person unless at the same time that person holds one ordinary share for each Existing RPS. |
Redemption |
· Existing RPS must be redeemed on the redemption date. Taxpayer has option to redeem the Existing RPS earlier than the redemption date. · Each Existing RPS must be redeemed in compliance with the requirements of the Corporations Act 2001. |
Subordination |
· Existing RPS rank equally amongst themselves and ahead of ordinary shares in respect of dividends and repayment of capital on a winding up · Although not a term of the Existing RPS, each RPS holder has separately agreed to subordinate their rights as Existing RPS holders to the claims of senior creditors in the Subordination Deed Poll. |
Voting Rights |
· An Existing RPS does not entitle its holder to vote at any general meeting except in respect of the following: · To reduce share capital of the subsidiary; · To vary or cancel any rights attaching to the Existing RPS; · To extend the term of the Existing RPS and/or refinance the Proposed RPS (both of which would require the holders of at least 75% (by value) of the Existing RPS then on issue; or · To approve the terms of a buy-back agreement |
Refinancing |
On or before the Redemption Date, the Existing RPS may be replaced with a new issue of RPS (on the same terms as the RPS then on issue) where the holders of at least 75% (by value) of the Existing RPS then on issue pass an appropriate resolution to subscribe for the new issue of the RPS. |
15. A relevant clause of Constitution 2 provides the general rights of the Existing RPS.
16. A relevant clause of Constitution 2 provides other rights attached to the Existing RPS including the company must pay to the holder of the RPS the Redemption Amount. Also, in the event that the company does not redeem each RPS on the Redemption Date the company must pay a Default Premium.
17. The Redemption date is defined in a relevant clause of Constitution 2 as being the 10th anniversary of the issue date or the date the company elected to redeem the RPS.
18. The Board of the taxpayer instructed management to investigate the options for refinancing the funding currently provided in relation to the Existing RPS.
19. A range of potential refinancing options were considered by the taxpayer including undertaking an issue of new RPS (the Proposed RPS) on substantially the same terms as the Existing RPS under the mechanism provided for in the Existing RPS Subscription Agreement. Other options considered were an extension to the Existing RPS, an issue of RPS with different terms, borrowing (externally and/or from one or more shareholders) to replace the Existing RPS, and/or an issue of ordinary shares to fund the redemption of the Existing RPS.
20. An issue of the Proposed RPS by the taxpayer was determined to be the preferred option on the basis that this was the simplest alternative to achieve the primary objective of obtaining certainty in relation to this funding in the required timeframe.
21. In accordance with the terms of the Existing RPS, the approval of at least 75% of the taxpayers RPS shareholders is required in order to refinance the Existing RPS on substantially the same terms. In this regard, it is noted that the approval of the requisite special majority of RPS shareholders is not guaranteed although initial inquiries of the shareholders in relation to this proposal has indicated that there is a good prospect that the proposal should achieve the required level of support.
22. Under the Proposed RPS scheme, a relevant clause of the Proposed RPS Subscription Agreement specifies that there are conditions precedent to the subscription including payment of the redemption premium to the holders of the Existing RPS and applying the subscription proceeds to redeem the existing RPS.
23. The terms of the Proposed RPS will be essentially the same as the Existing RPS with the following differences:
· the issue date will be 10 years after that specified in the Existing RPS and the corresponding maturity date will be the 10th anniversary of this issue date; and
· The coupon rate is likely to be reset by reference to the results of a contemporaneous benchmarking study that will be undertaken by an independent expert for this purpose. It is anticipated that the dividend coupon rate for the new RPS will be lower than the coupon rate for the existing RPS.
24. The Subordination Deed Poll (Existing RPS SDP) contains a subordination agreement by the Existing RPS holders. A relevant clause of this Existing RPS SDP states that no RPS may be redeemed by the taxpayer until the senior debt is repaid in full. The Existing RPS SDP allows the RPS to be redeemed by the taxpayer's subsidiary on the redemption date out of proceeds of a new issue of RPS in accordance with Constitution 2. An overriding clause exists and states this Deed applies despite any contrary agreement between the RPS holders and the taxpayer or any other financing document.
25. It is understood that each proposed RPS holder will agree to subordinate their rights to the claims of senior creditors according to the same terms and conditions as those contained in the Subordination Deed Poll for the Existing RPS.
Assumption
The Proposed RPS holders will agree to subordinate their rights to the claims of senior creditors according to the same terms and conditions as those contained in the 200X Subordination Deed Poll for the Existing RPS.
Relevant legislative provisions
Income Tax Assessment Act 1997, Division 974
Income Tax Assessment Act 1997, section 974-10
Income Tax Assessment Act 1997, section 974-15
Income Tax Assessment Act 1997, section 974-20
Income Tax Assessment Act 1997, section 974-35
Income Tax Assessment Act 1997, section 974-40
Income Tax Assessment Act 1997, section 974-70
Income Tax Assessment Act 1997, section 974-75
Income Tax Assessment Act 1997, section 974-85
Income Tax Assessment Act 1997, section 974-135
Income Tax Assessment Act 1997, section 974-155
Income Tax Assessment Act 1997, section 974-160
Income Tax Assessment Act 1997, Subdivision 974-B
Income Tax Assessment Act 1997, section 995-1
Corporations Act 2001, section 254K
Reasons for decision
Question 1
Will the proposed redeemable preference shares (Proposed RPS) to be issued by the taxpayer's subsidiary and the ordinary shares in the taxpayer on issue to the investors constitute related schemes for the purposes of section 974-155 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Summary
The Proposed RPS to be issued by the taxpayer's subsidiary and the ordinary shares in the taxpayer on issue to the investors will constitute related schemes for the purposes of section 974-155 of the ITAA 1997.
Detailed reasoning
A scheme is defined in Section 995-1 of the ITAA 1997 as any arrangement; or any scheme, plan, proposal, action, course of action or course of conduct whether unilateral or otherwise. On this basis, the ordinary shares issued by the taxpayer and the Proposed RPS to be issued by the taxpayer's subsidiary will each constitute a scheme.
Section 974-155 of the ITAA 1997 sets out the circumstances where two or more schemes will be treated as related schemes for the purposes of characterisation under Division 974 of the ITAA 1997.
Subsection 974-155(1) of the ITAA 1997 states:
Subject to subsection (3), 2 *schemes are related to one another if they are related to one another in any way.
Subsection 974-155(2) of the ITAA 1997 continues:
Without limiting subsection (1), 2 *schemes are related to each other if:
(a) the schemes are based on stapled instruments; or
(b) one of the schemes would, from a commercial point of view, be unlikely to be entered into unless the other scheme was entered into; or
(c) one of the schemes depends for its effect on the operation of the other scheme; or
(d) one scheme complements or supplements the other; or
(e) there is another scheme to which both the schemes are related because of a previous application or applications of this subsection.
It should be noted that only one of the points listed above in 974-155(2) need apply for 2 schemes to be considered related.
Each Proposed RPS to be issued by the taxpayer's subsidiary will be stapled to an ordinary share in the taxpayer. In particular, each Proposed RPS will be stapled to an ordinary share in the taxpayer and the Proposed RPS will not be able to be dealt with separately. Further, a clause of Constitution 2 specifies other rights attached to redeemable preference shares and states that the taxpayer's subsidiary is not entitled to issue a RPS to a person unless at the same time that person holds one ordinary share in the taxpayer for each RPS.
Therefore section 974-155 of the ITAA 1997 is satisfied on the grounds that the instruments are stapled and it is not required to further consider other grounds listed in subsection 974-155(2). The Proposed RPS and the ordinary shares in the taxpayer will be considered to be a related scheme.
Question 2
If the ordinary shares issued by the taxpayer and the Proposed RPS to be issued by the taxpayer's subsidiary are related schemes for the purposes of section 974-155 of the ITAA 1997, will the ordinary shares and Proposed RPS together give rise to a single notional debt interest in the taxpayer pursuant to subsection 974-15(2) of the ITAA 1997?
Summary
The ordinary shares and Proposed RPS will together give rise to a single notional debt interest in the taxpayer pursuant to subsection 974-15(2) of the ITAA 1997.
Detailed reasoning
In order for related schemes to give rise to single debt interest, the notional scheme must satisfy the criteria in paragraphs 974-15(2)(a) to (c) of the ITAA 1997.
Two or more related schemes (the constituent schemes) are taken together to give rise to a debt interest in an entity if:
(a) the entity enters into, participates in or causes another entity to enter into or participate in the constituent schemes; and
(b) a scheme with the combined effect or operation of the constituent schemes (the notional scheme) would satisfy the debt test in subsection 974-20(1) in relation to the entity if the notional scheme came into existence when the last of the constituent schemes came into existence; and
(c) it is reasonable to conclude that the entity intended, or knew that a party to the scheme or one of the schemes intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of a debt interest.
This is so whether or not the constituent schemes come into existence at the same time and even if none of the constituent schemes would individually give rise to that or any other debt interest.
The requirements of this subsection in relation to the taxpayer are considered below.
Paragraph 974-15(2)(a) of the ITAA 1997
Paragraph 974-15(2)(a) of the ITAA 1997 is satisfied because the taxpayer and its wholly owned subsidiary were or will be directly or indirectly involved in the issue of the ordinary shares and the Proposed RPS. The constituent documents clearly show that the taxpayer has the intention to enter into, participate in or cause other entities to enter into or participate in the related schemes.
Paragraph 974-15(2)(b) of the ITAA 1997
Paragraph 974-15(2)(b) of the ITAA 1997 requires that the notional scheme satisfies the requirements of the debt test in subsection 974-20(1) of the ITAA 1997.
Subsection 974-20(1) of the ITAA 1997 requires the following to be satisfied before a scheme can be said to give rise to a debt interest:
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).
Debt test for notional scheme:
These requirements of the debt test in relation to the notional scheme identified by the Commissioner, namely the ordinary shares on issue and the Proposed RPS are discussed below.
a) the scheme is a financing arrangement for the entity
Subsection 974-20(1) of the ITAA 1997 provides that the ordinary shares and Proposed RPS do not have to satisfy the financing arrangement requirement because they satisfy Item 1 of the table in subsection 974-75(1) of the ITAA 1997, being an interest as a member or stockholder of the company.
b) receipt of a financial benefit
Paragraph 974-160(1)(a) of the ITAA 1997 states that a financial benefit includes 'anything of economic value'. The taxpayer and its subsidiary received or will receive financial benefits in relation to the ordinary shares issued by the taxpayer and the Proposed RPS to be issued by its subsidiary.
The financial benefits received or to be received under the notional scheme:
i. the issue price for ordinary shares approximating $X;
ii. the issue price for Proposed RPS approximating $Y (notwithstanding in effect it has just replaced one source of funding with another).
Thus, the total financial benefits received or to be received by the taxpayer under the notional scheme approximates $(X + Y).
c) Effectively non-contingent obligation (ENCO) to provide a financial benefit
This element of the debt test requires that the entity has an ENCO under the scheme to provide a financial benefit or benefits to one or more entities.
Subsection 974-135(3) of the ITAA 1997 provides inter alia that an effectively non-contingent obligation is an obligation that is not contingent on any event, condition or situation other than the ability or willingness of that entity or connected entity to meet the obligation.
Ordinary shares
A clause of Constitution 1 specifies that the Director's have the power to declare dividends and that dividends shall not be paid except out of profit of the company and does not bear interest as against the company. There is no ENCO to provide a financial benefit under the ordinary shares as they are perpetual and any dividends payable thereon are contingent on the economic performance of the company.
Proposed RPS
There is an ENCO to provide a financial benefit under the Proposed RPS component of the notional scheme as a subsidiary of the taxpayer has an ENCO to redeem the Proposed RPS (a relevant clause of Constitution 2) for their Redemption Amount on or before the 10th anniversary of the issue date (a relevant clause of Constitution 2). Under a relevant clause of Constitution 2 this obligation is specified to be subject only to complying with the requirements of the Corporations Act 2001. Specifically section 254K of the Corporations Act 2001 provides that a company may only redeem redeemable preference shares out of profits or the proceeds of a new share issue. While this would represent an impediment on the subsidiary's ability to provide a financial benefit, subsection 974-135(5) of the ITAA 1997 specifically provides that an obligation to redeem a preference share is not contingent merely because there is a legislative requirement for the redemption amount to be met out of profits or the proceeds of a fresh issue of equity interests.
Each proposed RPS holder will agree to subordinate their rights to the claims of senior creditors according to the same terms and conditions as those contained in the Subordination Deed Poll (Existing RPS SDP) for the Existing RPS. This subordination agreement will be separate and is not contained in the Proposed RPS Subscription Agreement. A clause of the Existing RPS SDP states that no RPS may be redeemed by the taxpayer's subsidiary until the senior debt is repaid in full except for specified permitted receipts. Permitted receipts include the redemption of RPS at the redemption date out of proceeds from a new issue of RPS. An overriding clause exists that states that the Existing RPS SDP applies despite any contrary agreement between the RPS holders and the taxpayer's subsidiary or any other Financing Document.
The subordination arrangements do not render the obligation of the taxpayer's subsidiary to pay the redemption amount as contingent for the following reasons:
· The subordination arrangements will not affect the classification of the Proposed RPS as debt for tax purposes, as there is still an ENCO for the Proposed RPS to be redeemed by the taxpayer's subsidiary on the 10th anniversary of the issue date. The subordination arrangements are separate arrangements agreed to by the RPS holders.
· The RPS terms contained in Constitution 2 also include a default premium (equal to 1% of the issue price) payable if the RPS is not actually redeemed by the 10th anniversary of the issue date.
It is worth noting that there are also dividend entitlements under Constitution 2. However, as the payment of such financial benefits are non-cumulative; and contingent on the availability of funds and the taxpayer's subsidiary having received an interest payment from the taxpayer in respect of Notes issued by the taxpayer and held by the subsidiary, there is no ENCO to provide such dividends.
(d) it is substantially more likely than not that the benefit provided will at least equal the benefit received.
Paragraph 974-20(1)(d) of the ITAA 1997 requires it to be substantially more likely than not that the value of the financial benefit provided to the ordinary shareholders of the taxpayer and the proposed RPS holders under the notional scheme will be at least equal to the value of the financial benefit received by the taxpayer under the notional scheme.
Section 974-35 of the ITAA 1997 sets out the manner in which the value of a financial benefit to be provided or received under the scheme is to be calculated. Paragraph 974-35(1)(a) 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.
Subsection 974-35(3) defines the performance period as:
the period within which, under the terms on which the interest is issued, the effectively non-contingent obligations of the issuer, and any connected entity of the issuer, to provide a financial benefit in relation to the interest have to be met.
In addition, subsection 974-40(2) of the ITAA 1997 provides that the right or option of a party to terminate the scheme early is to be ignored in ascertaining the performance period unless those rights and obligations are themselves effectively non-contingent.
As noted above the taxpayer's subsidiary has an ENCO to redeem the Proposed RPS for their Redemption Amount on or before the 10th anniversary of the issue date.
As the performance period ends no later than 10 years after the interests arising from the notional scheme will be issued, the value of the Redemption Amount must be valued in nominal terms.
The Redemption Amount is equal to the value of financial benefits received by the taxpayer under the notional scheme. Therefore it is substantially more likely than not that the benefit provided will at least equal the benefit received and this element of the debt test is met.
(e) both the value provided and the value received are not both nil.
Paragraph 974-20(1)(e) requires that the value of the amounts provided and received are both greater than nil.
As outlined in (d) above the value provided and the value received are not both nil and this requirement is satisfied.
Conclusion re paragraph 974-15(2)(b) of the ITAA 1997
Paragraph 974-15(2)(b) of the ITAA 1997 is satisfied as all the requirements of the debt test have been satisfied in relation to the combined effect or operation of the notional scheme.
Paragraph 974-15(2)(c) of the ITAA 1997
Paragraph 974-15(2)(c) requires that
it is reasonable to conclude that the entity intended, or knew that a party to the scheme or one of the schemes intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of a debt interest.
This is interpreted by the taxpayer in the private ruling application that this paragraph is to be subjectively determined by the taxpayer. Further, it is argued that the taxpayer did not intend for the entire capital to be treated as a debt interest.
However, it is the Commissioner's interpretation of paragraph 974-15(2)(c) of the ITAA 1997 that the intention of the entity is to be concluded by a reasonable and independent observer based on the facts of the situation. Particular regard should be given as to whether the overall combined economic effects (not the legal effects) of the ordinary shares in the taxpayer and the RPS issued by its subsidiary are similar to that of a debt interest.
The taxpayer accepts that the RPS are debt interests, and the ordinary shares are equity interests. These instruments have been stapled together by the taxpayer and are not able to be bought or sold separately. It follows that this stapled relationship would cause an independent observer to conclude that these instruments were intended to be considered together for the purpose of Paragraph 974-15(2)(c) of the ITAA 1997. Consideration should be given to the relative values of these instruments. With the economic outlay for the RPS being ninety-nine times greater than the ordinary shares it is reasonable to conclude that parties to the schemes intended the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of a debt interest. Accordingly paragraph 974-15(2)(c) of the ITAA 1997 is satisfied.
Furthermore, it is argued by the taxpayer that the instruments can stand alone commercially and will not depend on or complement each other. The Commissioner disagrees with this assertion as the stapled nature of the overall scheme has allowed those who control the consolidated group through the ordinary shares to also provide the debt-like finance to the consolidated group which lowers the default risk of the arrangement. The stapled nature inherently causes the ordinary shares and RPS to depend on each other and indeed the equity and debt characteristics complement each other when packaged and proposed to the shareholders.
For the reasons explained above, paragraph 974-15(2)(c) of the ITAA 1997 is satisfied.
Conclusion on the application of subsection 974-15(2) of the ITAA 1997
The notional scheme identified by the Commissioner will give rise to a single notional debt interest in the taxpayer pursuant to subsection 974-15(2) of the ITAA 1997. However, in light of this finding it needs to be considered as to whether the Commissioner determines it unreasonable to apply this subsection pursuant to subsection 974-15(4) of the ITAA 1997.
Question 3
If it is considered that the ordinary shares and Proposed RPS will together give rise to a single notional debt interest in the taxpayer under subsection 974-15(2) of the ITAA 1997, will the Commissioner make a determination under subsection 974-15(4) of the ITAA 1997 that it would be unreasonable to treat the schemes as related schemes giving rise to a single notional debt interest in the taxpayer under subsection 974-15(2) of the ITAA 1997?
Summary
The Commissioner has made a determination under subsection 974-15(4) of the ITAA 1997 by the issuance of this Ruling that it would be unreasonable to treat the schemes as related schemes giving rise to a single notional debt interest under subsection 974-15(2) of the ITAA 1997.
Detailed reasoning
Subsection 974-15(4) of the ITAA 1997 provides:
Two or more related schemes do not give rise to a debt interest in an entity under subsection (2) if the Commissioner determines that it would be unreasonable to apply that subsection to those schemes.
Subsection 974-15(5) then provides:
Without limiting subsection 974-10(5), the Commissioner must, in exercising the power to make a determination under subsection (4), have regard to the following:
(a) the purpose of the schemes (considered both individually and in combination);
(b) the effects of the schemes (considered both individually and in combination);
(c) the rights and obligations of the parties to the schemes (considered both individually and in combination);
(d) whether the schemes (when considered either individually or in combination) provide the basis for, or underpin, an interest issued to investors with the expectation that the interest can be assigned to other investors;
(e) whether the schemes (when considered either individually or in combination) comprise a set of rights and obligations issued to investors with the expectation that it can be assigned to other investors;
(f) any other relevant circumstances.
The Commissioner is also to be guided by the objects provisions in section 974-10 of the ITAA 1997, in particular subsection 974-10(3) of the ITAA 1997 which requires, inter alia, that related schemes be taken into account in appropriate cases to ensure the test operates effectively on an economic substance of the rights and obligations arising under the schemes and to prevent the tests being circumvented by entities merely entering into a number of separate schemes instead of a single scheme.
The relevant factors that the Commissioner must have regard to in subsection 974-15(5) of the ITAA 1997 are considered below.
a) the purpose of the schemes (considered both individually and in combination)
Considered individually, the purpose of issuing the ordinary shares was to raise equity for the taxpayer and these ordinary shares governed by Constitution 1 include terms and conditions usually associated with ordinary shares such as:
· the right to receive dividends
· the right to participate in surplus capital on winding up
· the right to vote at any meeting of shareholders on the basis of one vote per share; and
· the right to appoint directors
Considered individually, the purpose of issuing the Existing RPS was to raise debt-like finance for the taxpayer's subsidiary. The Proposed RPS scheme is to replace the Existing RPS scheme which is approaching its expiry date and is mandatorily redeemable. An issue of a new RPS was determined by the taxpayer to be the preferred option for refinancing the Existing RPS on the basis that it was the simplest alternative of those considered to achieve the primary objective of obtaining certainty in relation to the funding in the required timeframe.
It has been stated by the applicant that the ultimate purpose of the schemes in combination (issuing the ordinary shares and the RPS) is to fund the taxpayer's investments.
This objective is achieved whether the schemes are carried out individually or in combination.
b) the effects of the schemes (considered both individually and in combination)
Having regard to the individual effects of the schemes the effect of the issue of the ordinary shares is to create an equity interest in the taxpayer. The dividends paid on the ordinary shares will be frankable, but not deductible, for the taxpayer.
The effect of the issue of the Proposed RPS is to create a debt interest in the taxpayer's subsidiary. The dividends paid on the Proposed RPS may be deductible for the taxpayer but only to the extent that the annually compounded internal rate of return does not exceed the benchmark rate of return for the interest increased by 150 basis points (the cap under subsection 25-85(5) of the ITAA 1997). They will not be frankable.
When considered in combination, the effect of the schemes is to create a notional debt interest in the taxpayer. On this basis, the dividends paid on the ordinary shares and the Proposed RPS may be deductible up to the previously mentioned cap in subsection 25-85(5) of the ITAA 1997 but they will not be frankable.
c) the rights and obligations of the parties to the schemes (considered both individually and in combination)
The ordinary shares carry those rights and obligations normally associated with an ordinary share investment such as providing investors with the risks and benefits associated with ordinary equity instruments such as bearing all residual risks of the company; voting rights and dividend entitlements contingent on economic performance and the exercise of the director's discretion.
There are, however, certain restrictions on shareholders transferring their ordinary shares (discussed in (d) below).
The shareholder lenders and redeemable preference share holders generally have the rights and obligations of unsecured lenders. Again there are certain restrictions on the redeemable preference share holders transferring their interests.
When considered in combination, the holders of the combined notional interest in the taxpayer have a right to an effectively fixed return on the redeemable preference shares (including the right to the return of their capital) and a return contingent on the economic performance of the taxpayer on the ordinary shares.
d) whether the schemes (when considered either individually or in combination) provide the basis for, or underpin, an interest issued to investors with the expectation that the interest can be assigned to other investors
A shareholder in the taxpayer can only assign its ordinary shares by assigning the same proportion of its redeemable preference shares as they are stapled instruments. A clause of Constitution 2 specifies that the taxpayer's subsidiary is not entitled to issue a RPS to a person unless at the same time that person holds one ordinary share in the taxpayer for each Existing RPS held in the subsidiary. Furthermore, an RPS cannot be transferred to another person unless in the same transaction the ordinary share in the taxpayer stapled to that RPS is also transferred to that person.
Therefore, there is nothing to prevent a shareholder from assigning its ordinary shares and redeemable preference shares (together) to another investor. As such, the schemes in combination (but not individually) provide the basis for an interest that is issued with the expectation that it can be assigned to other investors.
e) whether the schemes (when considered either individually or in combination) comprise a set of rights and obligations issued to investors with the expectation that the interest can be assigned to other investors
As noted above, the schemes in combination (but not individually) comprise a set of rights and obligations issued to investors with the expectation that the interest can be assigned to other investors.
f) other relevant circumstances
In addition to the above factors other relevant circumstances considered by the Commissioner include:
· the ordinary shares and Proposed RPS will be taken to have been issued separately (i.e. as part of different steps in the overall restructure);
· following the completion of the restructure, the taxpayers share capital funding will be structured as: ordinary shares (approximating $X) and Proposed RPS (approximating $Y);
· the shareholders are independent, arm's length parties with respect to each other and the taxpayer. No shareholder can control the taxpayer and the taxpayer cannot control the objectives or actions of any shareholder;
· if the notional scheme gives rise to a debt interest and the Commissioner did not exercise his discretion, the taxpayer would be rendered substantially without equity for tax purposes, upon which it could pay after-tax profits in the form of franked dividends;
· if all the ordinary shares were characterised as debt interests the profits of the company could not be distributed to these shareholders as frankable dividends. To the extent the company's profits were distributed on the ordinary shares, they could not be franked and the company could be denied a deduction for a part of the distribution under section 25-85 of the ITAA 1997. This would lead to an unwarranted accumulation of franking credits in the company.
Conclusion
In view of the totality of all the above factors, none of which by itself is conclusive, the Commissioner has made a determination under subsection 974-15(4) of the ITAA 1997 by the issuance of this Ruling that it would be unreasonable to treat the schemes as related. As a consequence it is now necessary to consider under Division 974 of the ITAA 1997 the characterisation of the ordinary shares and redeemable preference shares issued by the taxpayer on a stand alone basis. This is done below in Propositions 4 and 5.
Question 4
Will the Proposed RPS to be issued by the taxpayer's subsidiary be characterised as a debt interest in accordance with section 974-15 of the ITAA 1997?
Summary
The Proposed RPS issued to investors will be characterised as a debt interest in accordance with subsection 974-15(1) of the ITAA 1997.
Detailed reasoning
The rules for defining what constitutes equity and what constitutes debt in a company are set out in Division 974 of the ITAA 1997. Where an interest could be characterised as both a debt and equity interest, it will be treated as a debt interest. Accordingly, it is not necessary to apply the equity test if the debt test has been satisfied.
The 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 application of the debt test in subsection 974-20(1) of the ITAA 1997 to the Proposed RPS issued by the taxpayer's subsidiary is considered below.
a) the scheme is a financing arrangement for the entity.
Subsection 974-20(1) of the ITAA 1997 provides that the ordinary shares and Proposed RPS do not have to satisfy the financing arrangement requirement because they satisfy Item 1 of the table in subsection 974-75(1) of the ITAA 1997, being an interest as a member or stockholder of the company.
b) the entity, or connected entity of the entity, receives or will receive a financial benefit or benefits under the scheme.
The taxpayer's subsidiary will receive the issue price for each Proposed RPS and will therefore receive a financial benefit under the scheme as paragraph 974-160(1)(a) of the ITAA 1997 states that a financial benefit includes 'anything of economic value'.
c) 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.
The relevant financial benefits that fall for consideration under section 974-135 of the ITAA 1997 are the subsidiary's obligation to:
i) pay dividends on the Proposed RPS, and
ii) return the redemption amount.
The key terms and conditions in Constitution 2 that go to whether in substance or effect the taxpayer's subsidiary has an effectively non-contingent obligation in relation to these financial benefits are detailed below.
i) obligation to pay dividends
The taxpayer does not have an effectively non-contingent obligation to pay dividends in relation to the Proposed RPS because the payment of dividends is contingent on there being sufficient funds available in the taxpayer's subsidiary (a relevant clause in Constitution 2). Further, any unpaid dividends do not accumulate.
ii) obligation to return the redemption amount
The taxpayer will have an effectively non-contingent obligation to pay the redemption amount per Proposed RPS on or before the 10th anniversary of the issue date (a relevant clause of Constitution 2). For the Proposed RPS, the conditions are essentially to be the same as the Existing RPS specified in its Constitution with the following differences:
· the issue date will be 10 years after that specified in the Existing RPS and the corresponding maturity date will be the 10th anniversary of this issue date; and
· The coupon rate is likely to be reset by reference to the results of a contemporaneous benchmarking study that will be undertaken by an independent expert for this purpose. It is anticipated that the dividend coupon rate for the new RPS will be lower than the coupon rate for the existing RPS.
Under the terms of issue, dividends on the Proposed RPS are non-cumulative and are not to be included in the calculation of the Redemption Amount payable by the taxpayer's subsidiary upon redemption of the Proposed RPS.
Section 254K of the Corporations Act 2001 provides that a company may only redeem redeemable preference shares if the shares are fully paid-up (which is the case here) and out of profits or the proceeds of a new issue of shares made for the purpose of the redemption. Therefore, the redemption of the Proposed RPS is in a strict legal sense contingent upon the taxpayer's subsidiary having sufficient profits or being able to issue new shares for the redemption. However, subsection 974-135(5) of the ITAA 1997 specifically provides that an obligation to redeem a preference share is not contingent merely because there is a legislative requirement for the redemption amount to be met out of profits or a fresh issue of equity interests.
Furthermore, the taxpayer's subsidiary's obligation to redeem arises regardless of the fact that the Proposed RPS may be subordinated to the senior creditors. The subordination agreement does not render the obligation by the taxpayer's subsidiary to pay the redemption amount as contingent for the following reasons:
· The subordination arrangements will not affect the classification of the RPS as debt for tax purposes, as there is still an effectively non-contingent obligation for the RPS to be redeemed by the taxpayer's subsidiary on the 10th anniversary of the issue date. The subordination arrangements are separate arrangements agreed to by the RPS holders.
· The RPS terms also include a default premium (equal to 1% of the issue price) payable if the RPS are not actually redeemed by the 10th anniversary of the issue date.
· The right that the Proposed RPS holders have to a return may be said to be contingent on the taxpayer's subsidiary being able to meet its debts when they fall due. That by itself will not be taken as meaning that the right is contingent on the economic performance of the taxpayer's subsidiary (paragraph 974-85(1)(a) of the ITAA 1997 and explained in paragraph 2.30 of the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001).
On this basis, it is considered the separate subordination agreement between RPS holders do not make the redemption of the Proposed RPS a contingent obligation.
Thus, the taxpayer's subsidiary is under an effectively non-contingent obligation to provide a financial benefit to the holders of the Proposed RPS after the time it has received its financial benefits under the scheme.
d) it is substantially more likely than not that the benefit provided will at least equal to the benefit received.
It must be substantially more likely than not that the value of the financial benefits provided under the scheme will equal or exceed the value of the financial benefits received (paragraph 974-20(1)(d) of the ITAA 1997).
The value of the financial benefits provided is to be determined by reference to the term of the scheme/arrangement. In this regard:
· Where the performance period ends no later than 10 years after the interest is issued, the financial benefit is to be valued in nominal terms (paragraph 974-35(1)(i) of the ITAA 1997).
· Where the performance period must or may end more than 10 years after the interest is issued, the financial benefit is to be valued in present value terms (paragraph 974-35(1)(ii) of the ITAA 1997).
This has the effect that failing an earlier redemption of the redeemable preference shares they must be redeemed no later than 10 years from their issue date.
Thus, as the performance period ends no later than 10 years after the interest arising from the scheme will be issued the effectively non-contingent financial benefits must be valued in nominal terms (refer subsection 974-35(1) of the ITAA 1997).
Paragraph 974-20(1)(d) of the ITAA 1997 operates (in combination with subsection 974-20(2) of the ITAA 1997 and subsection 974-20(4) of the ITAA 1997) by determining the financial benefits (anything of economic value) that the entity has an effectively non-contingent obligation to provide under the scheme.
In addition, subsection 974-40(2) of the ITAA 1997 provides that the right or option of a party to terminate the scheme early is to be ignored in ascertaining the performance period unless those rights and obligations are themselves effectively non-contingent.
In this respect, it is noted that at the time of that the Proposed RPS are to be issued by the taxpayer's subsidiary, the Proposed RPS will need to be redeemed within 10 years of that time. Further, the Proposed RPS will not be a part of a broader scheme including the existing RPS. This is principally because the issue of the Proposed RPS is a separate arrangement to the issue of the Existing RPS, it is not under the control of either the taxpayer's subsidiary or the taxpayer (separately or together) and requires a minimum 75% RPS holder resolution (in addition to participation by the taxpayer and its subsidiary). On this basis, the value of the relevant financial benefits used to determine the value of the financial benefit will be calculated in nominal terms.
The redemption amount is at least equal to, and in this case more than, the value of the financial benefit received. Therefore, this requirement is met.
e) both the value provided and the value received are not both nil.
As the capital contributed to the taxpayer's subsidiary by the issue of the Proposed RPS will be a value greater than nil per preference share and the "Redemption Amount" due and payable by the taxpayer's subsidiary to the redeemable preference shareholders is to be greater than nil, this requirement is satisfied.
Conclusion
Therefore, all the requirements of the debt test have been satisfied in relation to the Proposed RPS and as a consequence they will be characterised as a debt interest in the taxpayer under subsection 974-15(1) of the ITAA 1997.
Question 5
Will the ordinary shares on issue by the taxpayer be characterised as an equity interest in accordance with section 974-70 of the ITAA 1997?
Summary
The ordinary shares issued to investors will be characterised as an equity interest in the taxpayer for the purposes of paragraph 974-70(1)(a) of the ITAA 1997.
Detailed reasoning
The rules for defining what constitutes equity and what constitutes debt in a company are set out in Division 974 of ITAA 1997. Where an interest could be characterised as both a debt and equity interest, it will be treated as a debt interest.
The equity test
Subsection 974-70(1) of the ITAA 1997 provides that:
A scheme gives rise to an equity interest in a company if, when the scheme comes into existence:
(a) the scheme satisfies the equity test in subsection 974-75(1) in relation to the company because of the existence of an interest; and
(b) 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.
These requirements in relation to the taxpayer's ordinary shares are considered below.
Scheme is defined in section 995-1 of the ITAA 1997 to include any arrangement or any scheme, plan, proposal, action, course of action or conduct. Thus, the issue of ordinary shares in the taxpayer is a scheme within this definition.
The taxpayer's ordinary shares satisfy the equity test in subsection 974-75(1) of the ITAA 1997 as the rights and privileges conferred on the ordinary shareholder by Constitution 1, subject to the limitations contained therein, include voting rights, dividend rights, and entitlements to surpluses upon a winding up.
The taxpayer's ordinary shares thus give the holder an interest in the company as a member or stockholder of the company and satisfy Item 1 of the table in subsection 974-75(1) of the ITAA 1997.
As a consequence there is no need to further consider other items in the equity table notwithstanding that the ordinary shares might also satisfy other items in the table as well (in particular items 2 and 3 of the equity table).
Subsection 974-75(1) of the ITAA 1997 has effect subject to subsection (2) which 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 (1) (other than item 1) does not give rise to an equity interest in the company unless the scheme is a financing arrangement for the company.
The taxpayer's ordinary shares do not have to satisfy the financing arrangement requirement because, as mentioned earlier, they satisfy Item 1 of the table in subsection 974-75(1) of the ITAA 1997.
Therefore, the taxpayer's ordinary shares satisfy the equity test in subsection 974-75(1) and they will give rise to an equity interest in the taxpayer provided 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 debt test
The application of the debt test to the taxpayer's ordinary shares is considered below.
a) the scheme is a financing arrangement for the entity.
As mentioned earlier the ordinary shares do not have to satisfy the financing arrangement requirement because they satisfy Item 1 of the table in subsection 974-75(1) of the ITAA 1997.
b) the entity, or connected entity of the entity, receives or will receive a financial benefit or benefits under the scheme.
The taxpayer has received the issue price for each ordinary share. The taxpayer has therefore received a financial benefit under the scheme as paragraph 974-160(1)(a) of the ITAA 1997 states that a financial benefit includes "anything of economic value".
(c) 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.
The relevant financial benefits that fall for consideration under section 974-135 of the ITAA 1997 are the taxpayer's obligation to:
i) pay a dividend on these ordinary shares; and
ii) return the issue price.
The key terms and conditions in Constitution 1 that go to whether in substance or effect the taxpayer has an effectively non-contingent obligation in relation to these financial benefits are detailed below.
i) Obligation to pay dividends
There is no requirement on the taxpayer to pay dividends on its ordinary shares in Constitution 1. Thus, any obligation to pay dividends is only a contingent obligation.
ii) Obligation to return the issue price
Ordinary shares are by their nature perpetual. There is nothing in the pricing, terms or conditions of the scheme to indicate that shares would be bought back or that the directors would wish to reduce the taxpayer's share capital. Thus, any obligation on the taxpayer to return any amount of the issue price of its ordinary shares to the shareholders is only a contingent obligation.
As the taxpayer is not under an effectively non-contingent obligation to provide any financial benefits to its ordinary shareholders, the debt test in section 974-20 of the ITAA 1997 is not satisfied.
Conclusion
As the taxpayer's ordinary shares pass the equity test but fail the debt test they will be equity interests for the purposes of paragraph 974-70(1)(a) of the ITAA 1997.
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