Edited version of your written advice

Authorisation Number: 1051458622446

Date of advice: 23 November 2018

Ruling

Subject: Application of Division 974 of the Income Tax Assessment Act 1997

Question 1

For the income year ended 30 June 20XX, are Convertible Notes issued by X classified as debt interests at the time of issue, in accordance with Division 974 of the ITAA 1997?

Answer

Yes.

Question 2

For the income year ended 30 June 20XX, are Convertible Notes issued by X classified as equity interests at the time of issue, in accordance with Division 974 of the ITAA 1997?

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

X issued Convertible Notes (Notes) during the year ended 30 June 20XX. The terms and conditions of the Notes are contained in the Convertible Note Deed (Deed) which binds X as the issuer and the Noteholder as the acquirer of the Notes.

The Notes were issued to fund the working capital requirements of X and its subsidiaries, including maintaining normal business activities and funding all research and development costs.

The Note has a face value of one Australian dollar. The interest rate on the Notes is y% per annum and is payable half yearly from the date of issue of the Notes, in arrears. The Notes expire 24 months after the date of issue or, if Noteholders approve a 12 month extension by ordinary resolution at a duly constituted meeting, then 36 months after the date of issue.

To incentivise the Noteholders, X incorporated features into the Notes that allowed the Noteholders to receive cash repayments or to convert the unpaid principal into ordinary shares. This was to provide the Noteholders with maximum flexibility to choose how they would ultimately be repaid for the financing they provided to X.

X provided a copy of the Deed, which details the obligations of the parties.

Key clauses of the Deed provide the Noteholders’ rights for either option, being conversion or redemption of the Notes. On expiry of a Note, X may elect to convert or redeem the Note; however, at a Noteholder’s discretion, a Noteholder may instead elect to convert of redeem a Note, contrary to the notice issued by X. This gives a Noteholder the final decision on whether to convert or redeem a Note.

Relevant legislative provisions

Income Tax Assessment Act 1997, subsection 974-5(4)

Income Tax Assessment Act 1997, subsection 974-15(1)

Income Tax Assessment Act 1997, paragraph 974-20(1)(a)

Income Tax Assessment Act 1997, paragraph 974-20(1)(b)

Income Tax Assessment Act 1997, paragraph 974-20(1)(c)

Income Tax Assessment Act 1997, paragraph 974-20(1)(d)

Income Tax Assessment Act 1997, paragraph 974-20(1)(e)

Income Tax Assessment Act 1997, paragraph 974-35(1)(a)(i)

Income Tax Assessment Act 1997, paragraph 974-70(1)(a)

Income Tax Assessment Act 1997, paragraph 974-70(1)(b)

Income Tax Assessment Act 1997, subsection 974-75(1)

Income Tax Assessment Act 1997, paragraph 974-130(1)(a)

Income Tax Assessment Act 1997, paragraph 974-130(1)(b)

Income Tax Assessment Act 1997, paragraph 974-130(1)(c)

Income Tax Assessment Act 1997, paragraph 974-130(2)(a)

Income Tax Assessment Act 1997, paragraph 974-130(2)(b)

Income Tax Assessment Act 1997, paragraph 974-130(2)(c)

Income Tax Assessment Act 1997, subsection 974-135(1)

Income Tax Assessment Act 1997, subsection 974-135(2)

Income Tax Assessment Act 1997, subsection 974-135(3)

Income Tax Assessment Act 1997, subsection 974-135(4)

Income Tax Assessment Act 1997, subsection 974-135(5)

Income Tax Assessment Act 1997, subsection 974-135(6)

Income Tax Assessment Act 1997, subsection 974-135(7)

Income Tax Assessment Act 1997, section 995-1

Public Rulings (including Determinations)

Taxation Ruling TR 2008/3

Reasons for decision

All legislative references are to provisions of the Income Tax Assessment Act 1997 (ITAA 1997) unless specified otherwise.

Question 1

For the income year ended 30 June 20XX, are Convertible Notes issued by X classified as debt interests at the time of issue, in accordance with Division 974 of the ITAA 1997?

Summary

The Convertible Notes issued by X are classified as debt interests at the time of issue, in accordance with Division 974.

Detailed reasoning

Subsection 974-15(1) 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, X.

The debt test

Subsection 974-20(1) provides that a scheme satisfies the debt test 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.

(Items marked with an asterisk (*) are defined in the dictionary at section 995-1).

Each of the requirements in paragraphs 974-20(1)(a) to (e) must be met for a scheme to satisfy the debt test. Each paragraph is considered in turn.

Paragraph 974-20(1)(a) – the scheme is a financing arrangement

‘Scheme’ is defined in section 995-1 as ‘any arrangement’. For the purposes of subsection 974-15(1), the scheme would be taken to comprise the Deed, as well as the issuances of the Notes to the Noteholders.

Therefore, the scheme that gives rise to the Notes is required to satisfy paragraph 974-20(1)(a).

Pursuant to subsection 974-130(1), a scheme is a ‘financing arrangement’ for an entity if it is entered into or undertaken:

(a) to raise finance for the entity (or a *connected entity of the entity); or

(b) to fund another scheme, or a part of another scheme, that is a *financing arrangement under paragraph (a); or

(c) to fund a return, or a part of a return, payable under or provided by or under another scheme, or a part of another scheme, that is a financing arrangement under paragraph (a).

Subsection 974-130(2) states that examples of schemes that are generally entered into or undertaken to raise finance are:

(a) a bill of exchange;

(b) income securities;

(c) a *convertible interest that will convert into an *equity interest.

Note: Paragraph (a) is likely to be relevant for debt interests, paragraph (b) for equity interests and paragraph (c) for both.

The scheme giving rise to the Notes was undertaken to fund working capital requirements of X and its subsidiaries, including maintaining normal business activities and funding all research and development costs and is, accordingly, a financing arrangement in accordance with paragraphs 974-130(1)(a) and 974-130(2)(c).

Therefore, the scheme giving rise to the Notes will satisfy paragraph 974-20(1)(a).

Paragraph 974-20(1)(b) – financial benefits received under the scheme

The Deed indicates X will receive approximately $z million from the issue of the Notes.

X will receive financial benefits in the form of funds deposited to X’s nominated bank account in respect of the issue of the Notes.

Therefore, the scheme giving rise to the Notes will satisfy paragraph 974-20(1)(b).

Paragraph 974-20(1)(c) – effectively non-contingent obligation to provide financial benefits

One of the key elements of the debt test is that a relevant entity, which, in practice, will usually be the issuer, must have an 'effectively non-contingent obligation' under the scheme to provide a financial benefit or benefits.

Any periodic interest payments by the issuer to the holder, and a payment by the issuer to the holder to return the amount invested in the interest will be relevant financial benefits, if the issuer is under an effectively non-contingent obligation to provide them.

'Effectively non-contingent obligation' is defined at section 974-135, and relevant parts of that section provide as follows:

(1) There is an effectively non-contingent obligation to take an action under a *scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action.

(2) Without limiting subsection (1), that subsection applies to:

(a) providing a *financial benefit under the *scheme; or

(b) terminating the scheme.

(3) An obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a *connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation.

(4) The existence of the right of the holder of an *interest that will or may convert into an *equity interest in a company to convert the interest does not of itself make the issuer's obligation to repay the investment not non-contingent.

(5) 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.

(6) In determining whether there is in substance or effect a non-contingent obligation to take the action, have regard to the artificiality, or the contrived nature, of any contingency on which the obligation to take the action depends.

(7) An obligation of yours is not effectively non-contingent merely because you will suffer some detrimental practical or commercial consequences if you do not fulfil the obligation.

The concept of an 'effectively non-contingent obligation to take an action under a scheme' has been adopted to facilitate consideration of the economic substance of arrangements, by reference to the pricing, terms and conditions of the scheme. The second reading speech and the explanatory memorandum (EM) to the New Business Tax System (Debt and Equity) Bill 2001 explains at paragraph 2.2:

The new rules classify an interest in a company as equity or debt according to the economic substance of the rights and obligations of an arrangement rather than its mere legal form in a more comprehensive way than the current law. Relevant to the classification is the pricing, terms and conditions of the arrangement under which the interest is issued.

The EM notes as follows:

2.174 Debt in a formal sense involves obligations which are non-contingent in legal form (e.g. a legal obligation to pay interest and to return principal). However, if the debt test were to focus solely on obligations which are non-contingent in legal form, schemes that are equivalent in economic substance might give rise to different tax outcomes. This would encourage tax arbitrage and open up tax avoidance opportunities.

2.175 The debt test therefore uses the concept of an effectively non-contingent obligation as opposed to a legally (or formally) non-contingent obligation. Thus a scheme under which an entity has a right but not a legal obligation to provide a financial benefit could nevertheless be debt if, having regard to the pricing, terms and conditions of the scheme, the entity is in substance or effect inevitably bound, to exercise that right....

2.176 The concept of an effectively non-contingent obligation is, however, not intended to displace regard to legal rights and obligations. This is particularly so where those rights and obligations are consistent with arm's length transactions of commercial substance and reflect the clear intention of the parties.

The reason for having an effectively non-contingent test rather than simply a formal contingency test is further explained at paragraph 2.178 of the EM as follows:

2.178... In this regard, reliance solely on a formal non-contingent test would enable taxpayers to easily impose artificial contingencies in order to prevent an interest being debt. In addition, consistent with the principle inherent in the debt test of focusing on economic substance rather than legal form, where a contingency is so remote as to be effectively inoperative (immaterially remote) it is as if the contingency did not exist and it should be disregarded.

Therefore, where the provision of a financial benefit on an instrument is formally subject to a contingency, that formal contingency may be disregarded if, upon consideration of the pricing, terms and conditions of issue of an instrument, the substance or effect of the arrangement is that the financial benefit will be provided by the issuer, despite the formal contingency. Artificial or contrived contingencies may be disregarded. A contingency that is immaterially remote, as explained above, will be disregarded.

On the other hand, if the formal terms of issue do not contain an express formal contingency, but it is apparent from a consideration of the pricing, terms and conditions of the scheme that there is, in substance or effect, an effective contingency that could prevent the provision of financial benefits, the obligation to provide financial benefits would be considered to be effectively contingent. The obligation will therefore not be 'effectively non-contingent'.

If there is a formal contingency that could affect the issuer's obligation to provide a financial benefit, and that contingency is not to be disregarded for the reasons noted above, the ostensible intention of the provisions is that the obligation is to be considered to be contingent unless a specific statutory exception applies.

Subsection 974-135(4) provides one such statutory exception. It provides a specific exception where a holder of a convertible interest has a right to convert the interest into an equity interest in a company. But for that exception, the issuer's obligation to return the issue price of an interest where the holder has a right to convert that interest into an equity interest in the issuer would be prima facie contingent upon the holder not exercising its right to convert the interest. The terms of subsection 974-135(4) provide that the existence of the right of the holder to convert an interest '...does not of itself make the issuer's obligation to repay the investment not non-contingent.'

Key clauses of the Deed provide Noteholders with a right to convert their Notes into Conversion Shares.

Ordinarily, X’s obligations to repay the issue price will be considered to be effectively contingent because of the mere existence of the Noteholder’s right to convert. However, the statutory exception in subsection 974-135(4) where the existence of the right of the holder of an interest that will or may convert into an equity interest in a company to convert the interest does not of itself make the issuer's obligation to repay the investment not non-contingent. Therefore, although the Noteholder has a right to convert, X still has an effectively non-contingent obligation to provide financial benefits to the Noteholder.

However, the Deed also provides X the right to convert the Notes into conversion shares:

Section 974-135 does not contain an exception that applies where the issuer, being X, has the discretion to convert the note into an equity interest in the issuer. X’s right to convert the Notes is a relevant contingency to consider for the purposes of the debt test. It affects the obligations of X to repay the investment, and to make any periodic payments on the investment.

Taxation Ruling TR 2008/3 Income tax: debt/equity - identification of any 'effectively non-contingent obligation' of an issuer of a convertible note to provide 'financial benefits' for the purposes of Division 974 of the Income Tax Assessment Act 1997 if the note can be converted at any time at the issuer's discretion into shares that are equity interests in the issuer company (TR 2008/3) considers whether the issuer of a convertible note has an 'effectively non-contingent obligation' to provide 'financial benefits' for the purposes of the debt test in Division 974 if the issuer can, at any time of its choosing after issue, exercise a discretion to convert the note into an equity interest in the issuer company.

TR 2008/3 states at paragraph 6 that:

The issuer of a convertible note that can be converted at any time, at the issuer's discretion, into a share that is an equity interest in the issuer, will not have an effectively non-contingent obligation to provide financial benefits for the purposes of paragraph 974-20(1)(c), unless that option to convert should be disregarded in light of the full consideration of the pricing, terms and conditions under which the note was issued.

On the face of it, it would appear X’s right to convert the Notes is a contingency to provide financial benefits and that X does not have an effectively non-contingent obligation to provide financial benefits. However, the full terms and conditions of the Deed under which the Notes were issued need to be considered before concluding that X does not have an effectively non-contingent obligation to provide financial benefits.

X can only convert a set number of days before the maturity date which is 24 or 36 months after issue of the Notes as stated in the Deed.

Key clauses of the Deed provide the Noteholders’ rights for either option, being conversion or redemption of the Notes that X elects.

It can be seen from these clauses that although X has a right to convert or redeem the Notes, the final decision of what to do with the Notes is with the Noteholder. For example, the Noteholders have a right, which effectively supersedes X’s right, to either elect to instead have the Notes redeemed or to agree to X’s election to convert the Notes.

Conversely, if X elects to redeem the Notes under the Deed, the Noteholders under can exercise their right to instead have the Notes converted or to agree to X’s election to redeem the Notes.

As the Noteholders have the final decision in regards to whether to convert or redeem the Notes, the operation of these rights in the Deed is comparable to that of an ordinary convertible note, where it is only the holder of the note that has the right to elect to convert. The application of subsection 974-135(4) to a case where the holder of the note has a right to convert the note into an equity interest provides that the issuer still has an effectively non-contingent obligation to provide financial benefits.

Accordingly, after consideration of the terms and conditions of the Deed, X has an effectively non-contingent obligation to provide financial benefits to the Noteholders.

Therefore, the scheme giving rise to the Notes will satisfy paragraph 974-20(1)(c).

Paragraph 974-20(1)(d) – it is substantially more likely than not that the value of the financial benefit provided will equal or exceed the value of the financial benefit received

The requirement of paragraph 974-20(1)(d) is that it has to be substantially more likely than not that the value of all the financial benefits to be provided under the scheme will be at least equal to the value of the financial benefits to be received under the scheme.

The value of the financial benefits is determined by subsection 974-35(1) by either nominal terms or present value terms. As the Notes issued by X have a performance period of 24 months, or 36 months if a 12 month extension has been approved by the Noteholders, then the value is to be calculated in nominal terms, per paragraph 974-35(1)(a)(i).

The provision of these financial benefits will be the repayment, in cash, of the face value of the issued Notes and the unpaid accrued interest on those Notes. Therefore, it is substantially more likely than not that the value of the financial benefits provided by X will equal or exceed the value of the financial benefits received.

Therefore the scheme giving rise to the Notes will satisfy paragraph 974-20(1)(d).

Paragraph 974-20(1)(e) – the financial benefits provided and received are not both nil

X will receive approximately $z million from the issue of the Notes and has an obligation to provide financial benefits of at least this amount. Accordingly, the financial benefits that X will provide and receive in respect of the Notes are not both nil.

Therefore the scheme giving rise to the Notes will satisfy paragraph 974-20(1)(e).

Conclusion

As each of the requirements in paragraphs 974-20(1)(a) to (e) are met in respect of the Notes, the Notes will give rise to a debt interest in X.

Question 2

For the income year ended 30 June 20XX, are Convertible Notes issued by X, classified as equity interests at the time of issue, in accordance with Division 974 of the ITAA 1997?

Summary

The Convertible Notes issued by X are classified as equity interests at the time of issue, in accordance with Division 974.

However, as the Convertible Notes are also classified as debt interests, they will be treated as a debt interest, by way of the tie breaker rule in subsection 974-5(4).

Detailed reasoning

Subsection 974-70(1) provides that a scheme gives rise to an equity interest in a company if the scheme, when it comes into existence, satisfies the equity test in subsection 974-75(1) in relation to the company, X.

The equity test

Subsection 974-75(1) provides that a scheme satisfies the equity test in relation to a company if it gives rise to an interest in the following table:

Equity interests
Item	Interest
1	An interest in the company as a member or stockholder of the company.
2	An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is in substance or effect *contingent on aspects of the economic performance (whether past, current or future) of: (a) the company; or (b) a part of the company's activities; or (c) a *connected entity of the company or a part of the activities of a connected entity of the company. The return may be a return of an amount invested in the interest.
3	An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of: (a) the company; or (b) a *connected entity of the company. The return may be a return of an amount invested in the interest.
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.

The Notes satisfy Item 4 of the equity test.

However, paragraph 974-70(1)(b) provides that a scheme does not give rise to an equity interest in a company if the scheme, when it comes into existence, is characterised as, and forms part of a larger interest that is characterised as, a debt interest in the company under Subdivision 974-B.

Subsection 974-5(4) provides that if an interest satisfies both the debt test and the equity test, it is treated as a debt interest and not an equity interest.

The Notes give rise to a debt interest in X, therefore they are not characterised as an equity interest.

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