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Edited version of your private ruling
Authorisation Number: 1012601456793
Ruling
Subject: Convertible preference shares and mandatory convertible notes
Issue 1
Question 1
Are the Convertible Preference Shares (CPS) an equity interest under subsection 974-75(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
Yes
Question 2
Are the Mandatory Convertible Notes (MCN) an equity interest under subsection 974-75(1) of the ITAA 1997?
Answer
Yes
Issue 2
Question 1
Will Part 3-95 of the ITAA 1997 apply to the amendments under the arrangement?
Answer
No.
Question 2
Where Part 3-95 of the ITAA 1997 does apply, will the amendments to the terms of the CPSs under the arrangement be a taxing event generating a gain under section 725-245 of the ITAA 1997?
Answer
Not applicable as the answer to Question 1 is No.
Question 3
Where Part 3-95 of the ITAA 1997 does apply, will the amendments to the terms of the CPSs under the arrangement result in an adjustment under section 725-250 of the ITAA 1997?
Answer
Not applicable as the answer to Question 1 is No.
Question 4
Where Part 3-95 of the ITAA 1997 does apply, will the amendments to the terms of the MCNs under the arrangement be a taxing event generating a gain under section 725-245 of the ITAA 1997?
Answer
Not applicable as the answer to Question 1 is No.
Question 5
Where Part 3-95 of the ITAA 1997 does apply, will the amendments to the terms of the MCNs under the arrangement result in an adjustment under section 725-250 of the ITAA 1997?
Answer
Not applicable as the answer to Question 1 is No.
Issue 3
Question
Will the provisions of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the actions provided for under the arrangement?
Answer
No
This ruling applies for the following period:
Year ended 30 June 20XX
The scheme commences on:
1 July 20XX
Relevant facts and circumstances
The partnership is one of the Australian investors in Convertible Preference Shares (CPSs) and Mandatory Convertible Notes (MCNs) issued by a non-resident company ('the company').
The key terms of the CPSs are stated as follows:
• Some of the CPSs are effectively 'stapled' to the company's ordinary shares (Ordinary Shares) and cannot be transferred without the Ordinary Shares.
• The CPSs entitle the holder to receive any dividends authorised from time to time.
• The CPSs do not confer voting rights at a general meeting of shareholders.
• The CPSs are entitled to share pari passu with Ordinary Shares in the distribution of surplus assets on liquidation of the company.
• The CPSs do not otherwise confer a right to participate in any profits or assets of the company, except as provided under the relevant legislations and the Shareholders Agreement.
• The CPSs can only be converted to Ordinary Shares on the Alteration Date, being the first to occur of the following dates:
(i) the date of commencement of liquidation of the company, the date of the removal of the company from the Register of Companies or of the appointment of a statutory manager,
(ii) the date of completion of a Change Event (being a sale of 100% of the issued share capital of the company, an IPO or a sale of either all of the operating subsidiaries of the company or the whole or a substantial part of the business of the company and its subsidiaries to an arms' length third party),
(iii) the date notified in writing by the company as the Alteration Date, and
(iv) following the notification of a Conversion Date for MCNs - the date notified in writing by any holder of CPSs.
The key terms of the MCNs are as follows:
• The company can elect to pay interest in respect of the MCNs on the day immediately before the anniversary of the issue date of the MCNs. If such an election is not made the company is taken to have elected not to pay the cash interest for that period and no obligation to pay cash interest for that period is taken to have accrued. However, on the Conversion Date the MCNs will be converted into additional ordinary shares.
• No MCN may be repaid, redeemed or repurchased.
• The MCNs can only be converted to Ordinary Shares on the Conversion Date, which is the same as for the CPSs
The company has not made any cash payment of interest on the MCNs or payment of dividends on the CPSs.
Under the arrangement, the company will take steps to:
• remove the non-taxable bonus issue on the CPSs, un-staple the CPSs from the Ordinary Shares (where applicable), and amend the terms of the CPSs so that they do not convert on a one for one basis, but instead each convert into the number of Ordinary Shares the current market value of which is equal to the CPS cancellation amount,
• buy back (on a pro rata basis) and cancel each CPS in consideration for a payment equal to the CPS cancellation,
• remove coupon on the MCNs, un-staple the MCNs from the Ordinary Shares (where applicable), and amend the terms of the MCNs so that they do not convert on a one for one basis, but instead each convert into the number of Ordinary Shares the total market value of which is equal to the number of MCNs multiplied by the CPS cancellation amount, and
• cancel each MCN in consideration for a payment equal to the CPS cancellation amount.
The CPS will be cancelled for an amount equal to the average capital contribution per share and accordingly the MCNs will also be cancelled for the same value and on the same basis to maintain shareholder parity (i.e., to ensure there is no economic shift in value between the company's shareholders).
The partnership holds Ordinary Shares, CPSs and MCNs on capital account and these assets were acquired or are taken to have been acquired after 20 September 1985.
The highest percentage of interest in the company is held by two main shareholders at under 30% each.
The two funds are not associates.
There is no "de facto" controller of the company in terms of subsection 727-355(3) of the ITAA1997.
Relevant legislative provisions
Income Tax Assessment Act 1997 Division 725
Income Tax Assessment Act 1997 section 974-15
Income Tax Assessment Act 1997 section 974-20
Income Tax Assessment Act 1997 section 974-50
Income Tax Assessment Act 1997 section 974-70
Income Tax Assessment Act 1997 section 974-75
Income Tax Assessment Act 1997 section 974-145
Reasons for decision
Issue 1
Question 1
Equity test
Section 974-75 of the ITAA 1997 sets out the requirements for a scheme to satisfy the equity test in relation to a company.
The term 'scheme' is defined broadly in subsection 995-1(1) of the ITAA 1997 to mean any arrangement, scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. The issue of the convertible preference shares (CPSs) would fall within the definition of a scheme.
A scheme gives rise to an equity interest in the company under section 974-70 of the ITAA 1997 if the scheme satisfies the equity test in section 974-75 and the interest is not a debt interest under section 974-20 of the ITAA 1997.
A scheme satisfies the equity test in relation to a company if it gives rise to an interest of the kind listed in subsection 974-75(1) of the ITAA 1997 which are:
1 |
An interest in the company as a member or stockholder. | |
2 |
An interest that carries a right to a variable or fixed return from the company where the right or the amount of the return is in substance or effect contingent on the economic performance (whether past, current or future) of the company or a "connected entity". | |
3 |
An interest that carries a right to a variable or fixed return from the company where the right or the amount of the return is at the discretion of the company or a connected entity. | |
4 |
An interest issued by the company that: | |
|
(a) |
gives its holder (or a connected entity of the holder) a right to be issued with an equity interest in the company or a connected entity of the company; or |
|
(b) |
is an interest that will or may convert into an equity interest in the company or a connected entity of the company. |
Each CPS will satisfy the equity test in subsection 974-75(1) of the ITAA 1997 as the interest arising from its issue is an interest covered by either or both of items 1 and 4 of the table listed in subsection 974-75(1) of the ITAA 1997.
Therefore, each CPS will be an equity interest unless they are characterised as debt interests under section 974-20 of the ITAA 1997.
Debt test
Subsection 974-20(1) of the ITAA 1997 provides that a scheme satisfies the debt test if:
a it is a financing arrangement for the entity, and
b the entity or a connected entity receives or will receive some financial benefit under the scheme, and
c the entity has, or both the entity and a connected entity have, an effectively non-contingent obligation under the scheme to provide financial benefit(s) to one or more entities after the time when the first of the financial benefits in (b) above is received, and
d it is substantially more likely than not that the value provided under (c) above will be at least equal to the value received under (b) above, and
e the value provided and the value received are not both nil.
Scheme is a 'financing arrangement'
The scheme which the company has entered into constitutes a 'financing arrangement' and
will therefore satisfy paragraph 974-20(1)(a) of the ITAA 1997.
Issuing entity receives 'financial benefit'
Subsection 974-160(1) of the ITAA 1997 provides that financial benefit:
(a) means anything of economic value; and
(b) includes property and services; and
(c) includes anything that regulations made for the purposes of subsection (3) provide is a financial benefit;'
even if the transaction that confers the benefit on an entity also imposes an obligation on the entity.'
The company has received the 'issue price' from the issue of each CPS. The total amount received from the shareholders who subscribed for the CPS will, therefore, constitute a 'financial benefit' for the purposes of paragraph 974-20(1)(b) of the ITAA 1997).
Issuing entity has an effectively non-contingent obligation to provide 'financial benefit'
The financial benefits that the company may provide to the holders of the convertible preference shares are as follows:
(1) Dividends:
There is no automatic right for convertible preference shares to participate in the profits or assets of the company. The dividends (if any) are payable at the discretion of the directors of the company.
Accordingly, the company will not have an effectively non-contingent obligation to make the dividend payments in respect of each CPS.
(2) Issue price:
The convertible preference shares have no 'maturity' date and there is no obligation on the company to redeem the convertible preference shares for cash.
Therefore, there is no effectively non-contingent obligation to provide a financial benefit to the holder in respect of the issue price of the convertible preference shares.
(3) Conversion:
The conversion of the CPS into Ordinary Shares does not constitute the provision of a financial benefit.
As the company will not have an effectively non-contingent obligation to provide any financial benefits in respect of the CPSs, the CPSs have failed the debt test as they do not satisfy paragraph 974-20(1)(c) of the ITAA 1997.
Conclusion
The CPSs issued by the company are considered to be equity interests as they satisfy the equity test in subsection 974-75(1) of the ITAA 1997 and are not characterised as, and do not form part of a larger interest that is characterised as, a debt test in subsection 974-20 (1) of the ITAA 1997.
Question 2
Equity test
The issue of the MCNs would fall within the definition of a 'scheme' for the purpose of section 974-75 of the ITAA 1997.
A scheme gives rise to an equity interest under section 974-70 of the ITAA 1997 if the scheme satisfies the equity test in section 974-75 and the interest is not a debt interest under section 974-20 of the ITAA 1997.
A scheme satisfies the equity test in relation to a company if it gives rise to an interest of the kind listed in the table in subsection 974-75(1) of the ITAA 1997 as stated above in Question 1.
Each MCN will satisfy the equity test in subsection 974-75(1) of the ITAA 1997 as the interest arising from its issue is an interest covered by item 4 of the table listed in subsection 974-75(1).
Therefore, each MCN will be an equity interest unless they are characterised as debt interests under section 974-20 of the ITAA 1997.
Debt test
Scheme is a 'financing arrangement'
The scheme which the company has entered into constitutes a 'financing arrangement' and will therefore satisfy paragraph 974-20(1)(a) of the ITAA 1997.
Issuing entity receives 'financial benefit'
The company has received the 'issue price' from the issue of each MCN. The total amount received from the shareholders who subscribed for the MCNs will, therefore, constitute a 'financial benefit' for the purposes of paragraph 974-20(1)(b) of the ITAA
1997).
Issuing entity has an effectively non-contingent obligation to provide 'financial benefit'
The financial benefits that the company may provide to the holders of the MCNs are as follows:
(1) Interest
There is no obligation to make a cash payment for the 'interest' on the mandatory convertible notes.
(2) Issue Price
The MCNs have no maturity date. That is, the MCN is a perpetual note. There is no obligation on the company to redeem the MCNs for cash.
(3) Conversion
The MCNs must mandatorily be converted into ordinary shares.
The issue of additional ordinary shares do not constitute the provision of a financial benefit under section 974-30 of the ITAA 1997.
Therefore, there is no effectively non-contingent obligation to provide a financial benefit to the holder of the MCNs in respect of the interest calculation, the face value or the conversion of the mandatory convertible notes.
Accordingly, it will not be possible for each of the MCNs to satisfy paragraph 974-20(1)(c) of the ITAA 1997.
Conclusion
The MCNs are considered to be equity interests as they satisfy the equity test in subsection 974-75(1) of the ITAA 1997and are not characterised as, and do not form part of a larger interest that is characterised as, a debt test in subsection 974-20 (1) of the ITAA 1997.
Issue 2
Question 1
The direct value shifting regime in Division 725 of the ITAA 1997 applies to a scheme that is entered into on or after 1 July 2002.
There is a direct value shift under a scheme involving equity or loan interests in an entity where there is a decrease in the market value of some equity or loan interest (down interest) and an increase or issue at a discount of other equity or loan interests (up interest): section 725-145 of the ITAA 1997.
Direct value shift
Section 725-50 of the ITAA 1997 requires that for there to be consequences under the direct value shifting rules under a scheme involving interests in a company or trust, four conditions need to be met:
• the controlling entity test in section 725-55 is satisfied (paragraph 725-50(b)),
• the participants in the scheme test in section 725-65 is satisfied (paragraph 725-50(c)),
• there are affected owners of interests in the target entity (paragraph 725-50(d)), and
• the exception in section 725-90 or section 725-95 does not apply (paragraph 725-50(e)).
Controlling entity test
The relevant controller tests are set out in section 727-355 of the ITAA 1997:
SECTION 727-355 Control (for value shifting purposes) of a company
50% stake test
727-355(1) An entity controls (for value shifting purposes) a company if the entity, or the entity and its *associates between them:
(a) can exercise, or can control the exercise of, at least 50% of the voting power in the company (either directly, or indirectly through one or more interposed entities); or
(b) have the right to receive (either directly, or indirectly through one or more interposed entities) at least 50% of any dividends that the company may pay; or
(c) have the right to receive (either directly, or indirectly through one or more interposed entities) at least 50% of any distribution of capital of the company.
40% stake test
727-355(2) An entity also controls (for value shifting purposes) a company if the entity, or the entity and it's *associates between them:
(a) can exercise, or can control the exercise of, at least 40% of the voting power in the company (either directly, or indirectly through one or more interposed entities); or
(b) have the right to receive (either directly, or indirectly through one or more interposed entities) at least 40% of any dividends that the company may pay; or
(c) have the right to receive (either directly, or indirectly through one or more interposed entities) at least 40% of any distribution of capital of the company;
unless an entity (other than the first entity and its associates) either alone or together with its associates in fact controls the company.
Actual control test
727-355(3)
An entity also controls (for value shifting purposes) a company if the entity, either alone or together with its *associates, in fact controls the company.
In the present case, the applicant claims that the economic interest percentage of the security holders is identical across:
(a) ordinary shares;
(b) CPSs and MCNs;
(c) The aggregate of (a) and (b).
This structure is intentional as each class of securities reflects the respective percentage of interest of the security holder in the company. The two highest percentage of interest is held by the two largest shareholders at under 30% each. They are not associates and so their interests are not aggregated for the purposes of determining if there is a controller.
Based on the respective rights of the securities, no individual security holder:
• controls at least 40% or 50% of the voting power in the company;
• has a right to receive at least 40% or 50% of the dividends payable on all the shares (ordinary and CPS) of the company; and
• will have a right to receive at least 40% to 50% of any distribution of capital of the company.
The applicant asserts that post-conversion there will be no 'controller' of the company on a fully diluted basis for the purposes of Division 725 (as defined in section 727-355 and 727-375 of the ITAA 1997).
The applicant has also asserted that there is no de facto controller of the company for the purposes of subsection 727-355(3) of the ITAA 1997.
As the controlling test is not met, the direct value shifting rules in Division 725 will not apply.
Conclusion
On the basis of information provided, it is considered that there is no entity that controls the company for the purposes of Division 725. As a result, Part 3-95 of the ITAA 1997 will not apply to the amendments under the terms of the arrangement.
Question 2:
Not applicable as the answer to Question 1 is No.
Question 3:
Not applicable as the answer to Question 1 is No.
Question 4:
Not applicable as the answer to Question 1 is No.
Question 5:
Not applicable as the answer to Question 1 is No.
Issue 3
Part IVA of the ITAA 1936
As determined above, there is no value shifting as a result of the proposed amendments under the arrangement. Accordingly, the amendments will not give rise to a tax benefit and Part IVA of the ITAA 1936, therefore, will not apply.
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