Edited version of private advice

Authorisation Number: 1052375266410

Date of advice: 19 March 2025

Ruling

Subject: Tax consequences - redeeming perpetual notes

Question 1

Are the Notes equity interests in Company A under Division 974?

Answer 1

Yes

Question 2

Will any Redemption Premiums paid by Company A on the redemption of the Notes be frankable distributions within the meaning of section 202-40?

Answer 2

Yes

Question 3

Will section 177EA apply to the issue or redemption of the Notes?

Answer 3

No

Question 4

Will section 204-30 apply to the issue or redemption of the Notes?

Answer 4

No

Question 5

Will section 45A apply in relation to a redemption of the Notes?

Answer 5

No

Question 6

Will section 45B apply in relation to a redemption of the Notes such that the Commissioner will make a determination under subsections 45C(1) or 45C(3) in relation to the ruling scheme?

Answer 6

No

Question 7

Will the commercial debt forgiveness rules in Subdivisions 245-C to 245-G apply to Company A in respect of any Notes that are redeemed for a Redemption Price that is less than the Issue Price of the Notes?

Answer 7

No

Question 8

Will a gain or profit that is assessable to Company A under section 6-5 arise as a consequence of the issue or redemption of the Notes?

Answer 8

No

Question 9

Does the issue or redemption of the Notes give rise to CGT event D1 for Company A pursuant to section 104-35?

Answer 9

No on issue.

Yes on redemption, but the notional CGT event won't result in a capital gain.

Question 10

Will Company A be required to recognise gains and losses under Division 230 in relation to the issue or redemption of the Notes?

Answer 10

No

Question 11

Are the Notes 'traditional securities' as defined in section 26BB?

Answer 11

No

Question 12

Where the Redemption Price for a Note is less than the Issue Price, will the shortfall be a capital loss for the purposes of Part 3-1 for the Investor (i.e. Company C and Company D)?

Answer 12

Yes

This ruling applies for the following period:

From 1 July XXXX until the redemption of any Notes that were issued during the period 1 July XXXX to 30 June YYYY. (For example, a Note issued on 30 June YYYY and subsequently redeemed will be covered by this ruling.)

This private ruling is based on the facts and circumstances set out below. If your facts and circumstances are different from those set out below, this private ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

1.          Company A is an Australian resident company, with one shareholder (Shareholder B), and it operates an investment business, investing in listed and unlisted securities and funds.

2.          Company A has entered an investment management agreement with Company C: Company C manages Company A's investment portfolio and receives a management fee and performance fee in return.

3.          Company C is also an Australian resident company.

4.          Company A wishes to allow Company C to invest in Company A's portfolio by issuing Notes, entitling Company C to a return that's linked to Company A's investment portfolio.

5.          Company A and Company C entered a Deed Poll governing the issue of these Notes.

6.          Company A issued X 'Initial Notes' to Company C with a total issue value of $X.

7.          Company D, another Australian resident investment company controlled by Shareholder B, may also subscribe for Notes in Company A.

8.          Company A has given the following reasons for issuing notes to Company C rather than shares.

•            This will allow (but not require) Company C to invest its own capital alongside Shareholder B.

•            To align the commercial interests between Shareholder B as shareholder and Company C.

•            To give Shareholder B as shareholder the right to decide when it will issue Notes.

•            To ensure the Notes don't introduce investors that have the right to vote in Company A, allowing Shareholder B to maintain full autonomy over his or her own affairs, and preserve the ability to pursue estate planning objectives.

•            To give Company A absolute discretion to selectively exit a Noteholder.

•            To avoid having to file documents with ASIC when Noteholders enter or exit.

•            To provide Noteholders with more flexibility and certainty about how to enter or exit their investments.

9.          Issuing Notes to other entities will be permitted.

10.       It's likely that Company C and Company D will be the only subscribers for additional Notes.

11.       On 30 June YYYY Company A's franking account balance was $X, arising from the receipt of franked dividend from Company E.

12.       The applicants supported their private ruling application with a copy of the Deed Poll governing the issue of loan notes by Company A under the scheme. The terms of the Deed Poll are incorporated within the facts of this private ruling. We summarise what we see as the significant terms in Table 1. However, the terms of the Deed Poll prevail over Table 1 if there's any inconsistency.

Table 1: summary of significant terms in the Deed Poll

13.       Included with the Deed Poll was an attached Investment Management Agreement between Company A and Company C. The terms of the Investment Management Agreement are incorporated within the facts of this private ruling. We summarise what we see as significant terms in Table 2. However, the terms of the Investment Management Agreement prevail over Table 2 if there's any inconsistency.

Table 2: summary of significant terms in the Investment Management Agreement

Assumptions

A.    The Deed Poll completely and accurately describes the Notes, is intended to have its legal effect, and will be implemented according to its terms.

B.    During the term of the ruling scheme, Company A and each of the Investors will be residents of Australia for tax purposes and will be residents of no other jurisdiction.

C.    All parties to the ruling scheme will be dealing with each other on arm's length terms and each Investor will provide fair value consideration to acquire the Notes.

D.    Any Redemption Premium paid by Company A will be franked at the same franking percentage as Company A's benchmark percentage for the franking period in which the payment is made.

E.    The quantum and timing of dividends on ordinary shares in Company A, and the level of attached franking credits in relation to such dividends won't materially change as a result of the Notes.

F.    Any Redemption Premiums paid on the redemption of Notes won't be sourced, directly or indirectly, from Company A's share capital account or non-share capital account or funded, directly or indirectly, by an issue of equity interests in Company A.

G.    Apart from any Redemption Premiums, the Redemption Price paid on redemption of Notes (i.e. the Issue Price or a lower amount if the Redemption Price is less than the Issue Price) will be entirely debited against Company A's non-share capital account.

H.    Immediately before the payment of any Redemption Premium on the Notes, Company A will have sufficient 'available frankable profits' (worked out under section 215-20) to pay the Redemption Premium.

I.      Company A hasn't elected into any of the Division 230 taxation of financial arrangement (TOFA) elective taxing methods.

J.     The Notes won't be trading stock (as defined in section 70-10) in the hands of Investors.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 6-5

Section 104-25

Section 104-35

Section 108-5

Section 110-25

Section 110-35

Section 110-55

Section 116-20

Section 202-40

Section 202-45

Section 204-30

Section 207-159

Section 215-10

Section 215-15

Section 230-45

Section 230-50

Section 230-225

Section 230-415

Section 245-10

Section 245-35

Section 245-36

Section 245-37

Section 960-120

Section 960-135

Section 974-15

Section 974-20

Section 974-35

Section 974-50

Section 974-70

Section 974-75

Section 974-85

Section 974-115

Section 974-120

Section 974-125

Section 974-130

Section 974-135

Section 974-145

Section 974-160

Section 975-300

Section 995-1

Income Tax Assessment Act 1936

Section 6

Section 26BB

Section 45

Section 45A

Section 45B

Section 45C

Section 47A

Section 70B

Section 109

Section 109C

Section 109J

Section 109K

Section 159GP

Section 159GSSSP

Section 177D

Section 177EA

Corporations Act

Small Business Guide

Does Part IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Question 1

Are the Notes equity interests in Company A under Division 974?

Answer

Yes

Summary

14.       A scheme will be classified as an equity interest under Division 974 if it passes the 'equity test' and isn't classified as a debt interest.

15.       Broadly, a scheme will pass the equity test if it carries a right to a return where the right or the amount is contingent on the company's economic performance, and certain exceptions don't apply.

16.       We think the Notes pass the equity test. The amount of the Redemption Price depends on the value of the Note Portfolio on redemption, which depends on the performance of Company A's investments. We address why we don't think the exceptions apply in the detailed explanation.

17.       We don't think the Notes will be classified as a debt interest. One of the requirements for a debt interest is that it's substantially more likely than not that the value provided is at least equal to the value received (calculated in present value terms where the scheme may exceed 10 years). We don't think that test is met here because the Notes are perpetual, and there's significant risk that the Redemption Price won't meet the threshold set by the relevant present value formula.

18.       Since the Notes pass the equity test and don't qualify as debt interests, it follows that they will be classified as equity interests.

Detailed explanation

19.       Rules in Division 974 classify interests as either 'debt' or 'equity' for tax purposes.

•            Subdivision 974-B is about debt interests. An interest is a 'debt interest' if it passes the debt test in section 974-20. (Section 974-15)

•            Subdivision 974-C is about equity interests. An interest will be an 'equity interest' if it isn't a debt interest and passes the equity test in section 974-75. (Section 974-70).

Company A's Notes won't be classified as debt interests: they fail the debt test in section 974-20 as, applying present value rules, it isn't substantially more likely than not that the Redemption Price will exceed the Issue Price.

20.       A scheme passes the debt test if it meets five conditions in paragraphs 974-20(1)(a) through (e).

21.       Two of those conditions are that:

•            (c) the entity has an 'effectively non-contingent obligation' to provide financial benefits to other entities under the scheme, and

•            (d) it's substantially more likely than not that the value provided is at least equal to the value received worked out under the section.

22.       We don't think the scheme passes the debt test because it doesn't meet the second condition.

Is there an effectively non-contingent obligation? Yes, because we think the formal contingencies are so remote they can be ignored.

23.       Section 974-135 is about the term 'effectively non-contingent obligation'.

•            There's an effectively non-contingent obligation if, having regard to pricing, terms, and conditions, there is in substance or effecta non-contingent obligation. (subsection 1)

•            An obligation is 'non-contingent' if it isn't contingent on an event, condition, or situation (including entity's economic performance) other than ability or willingness to meet an obligation. (subsection 3)

•            In determining whether there's in substance or effect a non-contingent obligation to take the action, have regard to the artificiality, or the contrived nature, of any contingency. (subsection 6)

24.       The Explanatory Memorandum to the bill introducing the debt equity rules[1] says this test is intended to focus on economic substance rather than legal form. It suggests the test would disregard contingencies that are so remote as to be effectively inoperative, or are so remote as to be theoretical rather than a real possibility of occurring. It also allows formally non-contingent obligations to be disregarded if the obligation doesn't exist in substance or effect.

25.       The same Explanatory Memorandum[2] also suggests returns of profits contingent on the entity having dividends would be contingent, even where it would be reasonable to expect a return and the possibility of not having profits is slight.

26.       Applying section 974-135, we think the test in paragraph 974-20(1)(c) is met. The Noteholder's return is a proportionate share of the value of the Note Portfolio at redemption. That means the return is contingent upon a) the Noteholder electing to redeem their notes, and b) the Note Portfolio having a positive value at redemption. While those things are formally contingent, we think the chance of them not happening is so remote that it can be ignored. Noteholders will almost certainly elect to redeem their Notes at some point because that's the only way they may recover value from their investment. (They don't pay interest or dividends.) While the Note Portfolio may well decline in value, it would be very unlikely to dwindle to nothing. Therefore, the remote contingencies can be ignored: Company A has a non-contingent obligation to provide a financial benefit to the Noteholder.

Is it substantially more likely than not that the value provided is at least equal to the value received? No, because present value rules apply to perpetual notes, and any returns on the Note Portfolio might not be enough to keep pace with inflation.

27.       The Explanatory Memorandum[3] to the bill introducing the debt equity rules says 'substantially more likely than not' is a higher standard than 'more likely than not' but a lower standard than 'highly likely'.

28.       Section 974-35 is about valuing financial benefits.

•            Subparagraph 974-35(1)(a)(i) says if the performance period must end no later than 10 years after the interest was issued, the value is calculated in nominal terms.

•            Subparagraph 974-35(1)(a)(ii) says if the performance period must or may end more than 10 years after the interest was issued, the value is calculated in present value terms.

•            Subsection 974-35(4) says an obligation is treated as having been met within 10 years if there's an effectively non-contingent obligation to terminate within 10 years.

29.       Section 974-50 says the present value of a financial benefit is calculated using the formula:

Nominal value/(1+adjusted benchmark rate of return)^n.

Where n is number of years ending when the financial benefit is provided, and adjusted benchmark rate of return is 75% of the benchmark rate of return.

Section 974-145 says 'benchmark rate of return' is an annually compounded internal rate of return on an equivalent ordinary debt interest.

30.       The Explanatory Memorandum at paragraph 2.193 and Example 2.22 suggests the present value method applies to perpetual instruments, with the formula being approximated to nominal value/adjusted benchmark rate of return (because 'n' would approach infinity).[4]

31.       The Macquarie Dictionary[5] says one meaning of 'substantial' is 'of ample or considerable amount, quantity, size, etc.: a substantial sum of money'.

32.       Applying section 974-35, we don't think Company A's obligation passes the test in paragraph 974-20(1)(d).

•            The performance period may be more than 10 years, so value will be calculated in present value terms.

•            The return will depend on the value of the Note Portfolio at the redemption time.

•            The value of the Note Portfolio will depend on investment performance. Investments managed by a professional investment manager would be subject to some risk. It seems relatively unlikely that the Note Portfolio will lose value in nominal terms (see the explanation for our answer to Question 11 at paragraphs 215 to 222). However, it seems a reasonable possibility that the Note Portfolio, while appreciating to some extent, would appreciate less than 75% of the benchmark rate of return, under the present value formula.

•            That risk is significant and not remote.

•            We think 'substantially more likely than not' requires more than a mere balance of probability test ('more likely than not').[6]

•            It follows that it isn't substantially more likely than not that the fund returns will exceed 75% of the benchmark rate of return.

33.       The Notes don't pass the debt test because they don't pass the 'substantially more likely than not' condition in paragraph 974-20(1)(d).

The equity test in section 974-75 is met, because the amount of the return is contingent on Company A's economic performance, and none of the exceptions apply.

34.       Section 974-70 says a scheme gives rise to an equity interest if the scheme satisfies the equity test, and the interest isn't characterised as a debt interest.

35.       An interest meets the equity test if it gives rise to an interest set out in the table in subsection 974-75(1) and isn't excluded by exceptions in the remainder of the section.

Item 2 in the table in subsection 974-75(1) is met because the amount of the return is contingent on Company A's economic performance.

36.       Item 2 in that table relevantly covers 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 of the company, or part of its activities.

(Item 2 clarifies that the return may be a return of an amount invested in the interest.)

37.       Section 974-85 says a right, or amount of a return, is contingent on aspects of the economic performance of an entity, or part of the entity's activities, if the right or return is contingent on the entity's economic performance, but not solely because of ability or willingness to satisfy the right, or the entity's receipts or turnover.

38.       Item 2 is met because the return depends on Company A's performance. The Noteholder receives a return of a proportionate share of the value of the Note Portfolio. (The Note Portfolio is made up of investments bought with subscription proceeds for the Notes.) The amount of that return will depend on the economic performance of those investments - which is at least a part of the company's activities. Item 2 in the table in section 974-75 is met.

39.       Section 974-75 sets out some exceptions to the equity test. Two relevant ones are:

•            subsection 974-75(2), for equity schemes that aren't financing arrangements, and

•            subsection 974-75(6), for at-call loans.

40.       We'll address each exception in the following paragraphs.

The exception in subsection 974-75(2) for equity schemes that aren't financing arrangements doesn't apply, as we think this is a financing arrangement.

41.       Subsection 974-75(2) says 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 as members/stockholders) doesn't give rise to an equity interest in the company unless the scheme is a financing arrangement for the company.

42.       Section 974-130 says a scheme is a financing arrangement if it's entered into/undertaken to raise finance for the entity.

43.       The Explanatory Memorandum[7] to the bill introducing the debt/equity rules at paragraph 2.7 says:

•            raising finance generally entails a contribution to the entity's capital (whether by money, property, or services) in respect of which a return is paid by the entity (whether contingent or non-contingent)

•            it's important to consider all relevant circumstances and features to determine whether, in substance, it's characterised as a financing arrangement

•            intentions of the parties are relevant but not determinative.

44.       The same Explanatory Memorandum[8] at paragraph 2.8 says issuing a debt/equity hybrid instrument for consideration (whether for money, property, or services) would usually constitute a financing arrangement.

45.       TD 2004/83[9] at paragraph 12 says it's fundamental to the concept of a financing arrangement that there be a provision of resources for use in an entity's enterprise in exchange for some form of future return.

46.       This exception doesn't apply because the arrangement isa financing arrangement. Issuing the Notes will require the prospective Noteholder to contribute money (the Issue Price) to Company A and redeeming them requires Company A to pay a redemption payment to the Noteholder. That's a capital contribution which will fund a future return (the Redemption Price).

The exception in subsection 974-75(6) for at-call loans doesn't apply, because Company A's Notes aren't loans.

47.       Subsection 974-75(6) says the scheme is taken to give rise to a debt interest instead ofan equity interest where:

•            the scheme takes the form of a loan to a company by a connected entity

•            the loan doesn't have a fixed term

•            the loan is either repayable on demand or on death

•            the company's GST turnover is less than $20M.

48.       SMSFR 2009/2[10] at paragraphs 34-35 discusses the ordinary meaning of 'loan'. It says broadly a loan involves giving money or property with an understanding that the recipient will repay (either on demand or at a fixed time).

49.       The Notes aren't in the form of a loan, because the obligation is to pay a proportion of a capital pool that's purchased with the principal sum: there's no necessary correlation or identity between the principal sum and the repayment.

Conclusion: Company A's Notes are classified as equity interests because they pass the equity test and don't pass the debt test.

50.       The arrangement will be classified as an equity interest rather than a debt interest.

51.       The Notes don't meet the debt test. It isn't substantially more likely than not that the value of the financial benefits Company A pays are more than the financial benefits Company A receives. Therefore, the condition in paragraph 974-20(1)(d) is failed.

52.       The Notes do meet the equity test. They meet Item 2 of the table in subsection 974-75(1) because the return to Noteholders is contingent on Company A's economic performance. None of the exceptions in section 974-75 apply.

53.       The Notes are classified as equity interests because they meet the equity test and don't meet the debt test.

Question 2

Will any Redemption Premiums paid by Company A on the redemption of the Notes be frankable distributions within the meaning of section 202-40?

Answer

Yes

Summary

54.       Distributions are frankable if they don't fall within any of a list of unfrankable distributions in section 202-45.

55.       We don't think the Redemption Premium component of the redemption amounts fall within any items in that list of unfrankable distributions for reasons we give in the detailed explanation.

56.       Since the Redemption Premiums aren't made unfrankable by section 202-45, it follows that they are frankable distributions.

Detailed explanation

Distributions are frankable distributions if they don't fit any of the negative categories of 'unfrankable distributions' in section 202-45.

57.       Section 202-40 says a distribution is a frankable distribution if it isn't unfrankable under section 202-45.

58.       Section 202-45 says a list of distributions in paragraphs 202-45(c) through (j) are unfrankable.

59.       We list unfrankable distributions in the left-hand column in Table 3.

60.       We consider the Redemption Premiums against the conditions for each type of unfrankable distribution and conclude that they don't meet those conditions in the right-hand column of Table 3.

Table 3 - list of unfrankable distributions in section 202-45

Section 207-159 is an integrity rule that applies where the principal effect and purpose of issuing equity interests was to fund a substantial part of a relevant distribution.

61.       Section 207-159 is an integrity rule introduced in 2023, broadly about franked distributions funded by a capital raising. Section 207-159 applies if four conditions in subsection (1) are satisfied.

•            Either the entity doesn't have a practice of making distributions of the relevant kind, or it has a practice but didn't distribute in accordance with that practice.

•            There's an issue of equity interests before, at, or after the time the relevant distribution was made.

•            It's reasonable to conclude that:

o   the principal effect of issuing the equity interests was directly or indirectly funding a substantial part of the relevant distribution, and

o   an entity that issued the equity interests did so for a purpose (other than an incidental purpose) of funding a substantial part of the relevant distribution.

•            Issuing the equity interests wasn't a direct response to meet an ASIC/APRA requirement, direction, or recommendation.

•            The first, second, and fourth conditions in section 207-159 are met. When Company A begins making payments on redemption it won't have an established practice of making distributions of that kind.

•            Company A will have issued Notes before the relevant distributions, and we concluded in Question 1 that the Notes are classified as equity interests for tax purposes.

•            The facts don't disclose that Company A issued the Notes to meet any requirement, direction, or recommendation from ASIC or APRA.

62.       We'll make a few points about the third condition.

•            The Explanatory Memorandum to the bill that introduced section 207-159[11] describes the two limbs of the third condition as the 'principal effect' test and the 'purpose' tests: see paragraph 5.34.

•            The Macquarie Dictionary[12] says 'principal' means 'first or highest in rank, importance, value, etc.; chief; foremost', or 'something of principal or chief importance'.

•            The Macquarie Dictionary[13] also says 'indirect' means ''coming or resulting otherwise than directly or immediately, as effects, consequences' or 'not straightforward' or 'not direct in bearing, application, force, etc.'.

•            The Explanatory Memorandum to the bill introducing section 177EA[14] says that a purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with another purpose, or merely follows another purpose as its natural incident. (The imputation benefit is a natural incident of holding shares in the ordinary way to obtain the benefit of any increase in their share price and the dividend income flowing from the shares.) See paragraph 8.76.

•            Both sections 207-159 and 177EA are integrity rules relevant to imputation credits, so we think 'incidental purpose' would have the same meaning.

•            The Explanatory Memorandum[15] to the bill introducing section 207-159 at paragraph 5.16 says the provision addresses arrangements that are entered into for a purpose (other than an incidental purpose) and with the principal effect of accelerating the release of franking credits and which are typically artificial or contrived: the absence of any meaningful change to the financial position of the entity will usually be a feature of such arrangements.

Section 207-159 won't apply: we think funding the Redemption Premium isn't the 'principal effect' because it's a step removed and depends on subsequent events.

63.       We think the 'principal effect' test (the first limb of the third condition) won't be met on these facts.

•            Here, we think the principal effect of issuing Notes is to give Company A funds to buy investment assets that will form the Note Portfolio.

•            Issuing Notes will indirectly fund the Redemption Premium because the Redemption Price, including the Redemption Premium, will be funded from investment growth on the Note Portfolio, and that Note Portfolio was purchased from the Note proceeds. The Redemption Premium is an effect or consequence that flows from Issuing Notes, so the equity issue will have indirectly financed the distribution.

•            However, we think funding the Redemption Premium is too remote to be the 'principal effect' of issuing Notes. The immediate consequence of the equity issue is to buy investments for the company and give the Noteholder an investment that may fluctuate in value based on investment performance. A Redemption Premium will only be paid if a) the Noteholder or Company A decides to redeem, and b) the Note Portfolio's value is greater at that time than at the issue time. We don't think funding the Redemption Premium can be characterised as the principal (chief or most important) effect of issuing notes since its contingent on two subsequent events: redemption and capital growth.

64.       It follows that section 207-159 won't apply because the first limb of the third condition ('the principal effect' test isn't met.

Conclusion: the Redemption Premiums are frankable distributions.

65.       The Redemption Premiums are frankable distributions because none of the items in section 202-45 apply to make them unfrankable.

Question 3

Will section 177EA apply to the issue or redemption of the Notes?

Answer

No

Summary

66.       Section 177EA is an integrity provision that may apply to schemes entered into for a non-incidental purpose of getting an imputation benefit.

67.       We think that the main purpose of this scheme is to allow Noteholders to invest and receive returns on investments, and getting an imputation benefit is merely incidental to that purpose.

68.       Section 177EA doesn't apply to the scheme the purpose of getting an imputation benefit is merely incidental.

Detailed explanation

One of the requirements for section 177EA to apply is that the scheme was entered into for a non-incidental purpose of getting an imputation benefit.

69.       Section 177EA is an integrity provision that applies to schemes entered into for a non-incidental purpose of getting an imputation benefit.

70.       Subsection 177EA(3) says the section applies if five conditions in paragraphs 177EA(3)(a) through (e) are met.

•            (a) There's a scheme for the disposition of membership interests, or an interest in membership interests, in a corporate tax entity.

•            (b) A frankable distribution has been paid, is payable, or is expected to be payable to a person in respect of the membership interests (or has flowed, flows, or is expected to flow indirectly).

•            (c) The distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit.

•            (d) Except for this section, the relevant taxpayer would receive (or could reasonably be expected to receive) imputation benefits as a result of the distribution.

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

71.       We'll pass over the conditions in paragraphs 177EA(3)(a) through (d), and move to the imputation benefit purpose condition in paragraph 177EA(3)(e).

The purpose of enabling the relevant taxpayer to obtain an imputation benefit isn't present here: we think Noteholders are exposed to the risks and rewards of ownership, so the imputation benefit merely follows as an incidental feature of the scheme.

72.       The Explanatory Memorandum to the bill introducing section 177EA[16] at paragraph 8.76, said that 'incidental purpose' meant fortuitously or in subordinate conjunction, or merely following another purpose as a natural incident.

73.       Subsection 177EA(17) lists some circumstances relevant to determining the scheme's purpose. We won't list all the relevant circumstances. However, they include (at paragraph a) the extent and duration of the risks of loss, and opportunities for profit and gain from membership interests, and (at paragraph b) whether a taxpayer would derive a greater benefit from franking credits than other entities holding membership interests.

74.       The Explanatory Memorandum to the bill introducing section 177EA at paragraph 8.83 said the greater the risks and opportunities of a person otherthan the recipient, the more likely that the purpose of obtaining an imputation benefit is present, especially where the same person had the risks before, during, and after the taxpayer received the franking credit.[17]

75.       TR 2009/3[18] made these points about section 177EA.

•            It cites paragraph 2.5 of the Supplementary Explanatory Memorandum to say that artificiality, contrivance, uncommercial features, or features that appear to stultify the real purpose of share ownership may suggest a purpose of tax avoidance. [30]

•            Where an interest designed to be an equity interest under Division 974 delivers imputation benefits withoutexposing them to risks and opportunities, that raises a question about the appropriateness of them receiving that benefit. It appears to 'stultify the real purpose' of owning equity. [47]

76.       Considering the relevant circumstances in subsection 177EA(17), we think the purpose of obtaining an imputation benefit is merely an incidental purpose of the scheme. The scheme's purpose is to allow other parties to invest (and receive returns on investments) through the company. The return (Redemption Price, based on the Redemption Value) tracks capital growth or decline in the company. While they will get an imputation benefit, we think they experience the same opportunities for gain and risks of loss as shareholders. (This points against the relevant purpose: see the Explanatory Memorandum at paragraph [8.82]). Therefore, the imputation benefit merely follows as a natural incident of the scheme, and is merely incidental to the purpose of investing and receiving returns on investments (See the Explanatory Memorandum at paragraph [8.76]).

77.       Broadly, we think the risks and opportunities of the Notes are equivalent to equity ownership. To adopt the language of TR 2009/3 at paragraph [47], the Notes don't deliver imputation benefits without exposing the Noteholders to appropriate risks and opportunities: rather, we think the Noteholders face the risk of loss and opportunities to gain normally associated with owning equity. We don't see undue artificiality or contrivance: the tax treatment and economic substance line up.

78.       Since we don't think there's a more than incidental purpose of obtaining an imputation benefit, paragraph 177EA(3)(e) isn't met.

Conclusion: section 177EA won't apply because the fifth condition isn't met.

79.       Section 177E won't apply because the fifth condition in paragraph 177EA(3)(e), about a more than incidental purpose of obtaining an imputation benefit, isn't met.

Question 4

Will section 204-30 apply to the issue or redemption of the Notes?

Answer

No

Summary

80.       Speaking loosely, section 204-30 denies franking credits (or creates franking debits) where an entity streams distributions in a way that imputation benefits go to advantaged members who get more of a benefit from them, and other members who don't benefit miss out.

81.       Section 204-30 won't apply in this case because the only relevant members are Australian residents and should receive equal benefits from franking credits.

Detailed explanation

Section 204-30 applies where an entity streams distributions so that they go to members who benefit more from imputation benefits than others, and the other members receive lesser imputation benefits.

82.       Section 204-30 empowers the Commissioner to make determinations when distributions are streamed.

83.       Subsection 204-30(1) allows the Commissioner to make determinations if an entity streams one or more distributions (or one or more distributions and the giving of other benefits) in such a way that:

•            an imputation benefit is, or apart from this section would be, received by a member of the entity as a result of the distribution or distributions

•            the member would derive a greater benefit from franking credits than another member, and

•            the other member will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits.

84.       Where subsection 204-30(1) applies, subsection 204-30(3) says that the Commissioner may make determinations denying imputation benefits or causing a franking (or exempting) debit to arise in the entity's franking (or exempting) account.

85.       The Macquarie Dictionary[19] lists multiple meanings of 'stream', as including 'a continuous flow or succession of anything,' or 'prevailing direction; drift'.

86.       Subsection 204-30(2) says examples of 'other benefits' include bonus shares, returning paid-up share capital, forgiving a debt, making a payment, or giving property.

87.       Subsections 204-30(7), (8), (9), and (10) list the following (not exhaustive) examples of when a member derives a greater benefit from franking credits than another.

•            The other member is a foreign resident, wouldn't be entitled to a tax offset, would pay less tax than the offset, or is a company which can't receive a franking credit: subsection 204-30(8).

•            A franking credit arises for the first member, or the first member is entitled to a tax offset, and the other member isn't entitled: subsection 204-30(9).

•            The first member is entitled to a tax offset under section 210-170 and the other member isn't. (Section 210-170 is about franked distributions for venture capital investors.)

Section 204-30 won't apply because all members will benefit equally from franking credits.

88.       The condition in paragraph 204-30(1)(b) won't be met. It requires that the recipient member would derive a greater benefit from franking credits than another member of the entity. The facts don't disclose any reason (such as foreign residency) why Company A's only shareholder (Shareholder B) would receive any lesser benefit from franking credits than Noteholders.

89.       At least one of the conditions in subsection 204-30(1) isn't met, so section 204-30 won't apply to the issue or redemption of the Notes.

Question 5

Will section 45A apply in relation to a redemption of the Notes?

Answer

No

Summary

90.       Section 45A applies if a company streams the provision of capital benefits and the payment of dividends so that the capital benefits go to 'advantaged shareholders' who receive a greater benefit from capital benefits, and the remainder obtain dividends.

91.       We don't think section 45A will apply here because the facts and circumstances of the scheme don't disclose circumstances suggesting the Noteholders will have relevantly different characteristics from Company A's ordinary shareholders.

Detailed explanation

Section 45A applies where a company streams capital benefits to advantaged shareholders and dividends to disadvantaged shareholders.

92.       Section 45A is about streaming dividends and capital benefits. Subsection 45A(1) says the section applies if a company streams capital benefits and dividends to its shareholders in such a way that:

•            the capital benefits go to 'advantaged shareholders' who derive a greater benefit from them than other shareholders, and

•            it's reasonable to assume that the other 'disadvantaged shareholders' have received or will receive dividends.

93.       Other provisions are relevant to the meaning of 'capital benefit' in this context.

•            Subsection 45A(3) says the provision of a capital benefit includes the provision of shares in the company, the distribution of share capital or share premium, and something done to a share that has the effect of increasing the value of a share.

•            Subsection 45A(3A) says for the purposes of the section, a non-share distribution to an equity holder is taken to be the distribution of share capital to the extent it it's a non-share capital return.

•            'Share capital' and 'share premium' aren't defined.[20]

•            Section 6 says 'share', 'non-share distribution', 'non-share equity interest', and 'non-share capital return' take their meaning from the ITAA 1997.

•            Section 995-1 says 'share' means a share in the capital of the company, including stock.

•            Section 974-115 says a company makes a 'non-share distribution' to you if you hold a non-share equity interest, and the company distributes money or other property to you as the holder of that interest.

•            Section 995-1 says 'non-share equity interest' means an equity interest in the company that isn't solely a share.

•            Section 974-125 says 'non-share capital return' is a non-share distribution to the extent it isn't a non-share dividend.

•            Section 974-120 says all non-share distributions are non-share dividends, except to the extent the company debits it against the company's non-share capital account or share capital account.

94.       Part of the Redemption Price may amount to a capital benefit under section 45A.

•            Notes arguably amount to shares because they give the holders a share in Company A's capital.

•            If that's right, then issuing Notes would be a capital benefit under subsection 45A(3) as the 'provision of shares', and the Redemption Price may be a distribution of share capital or share premium under the same subsection.

•            If the Notes aren't shares, then they are 'non-share equity interests' because we concluded at Question 1 that the Notes were equity interests.

•            If the Notes are non-share equity interests, then the amount of the Redemption Price up to the Issue Price would be a non-share capital return (as it's debited to the Note capital account), and the remaining Redemption Price would be a non-share dividend.

•            A non-share capital return amounts to a capital benefit under subsection 45A(3A).

95.       Subsection 45A(4) gives a non-exhaustive list of examples where a shareholder derives a greater benefit from capital benefits than another shareholder. They include where any of the following circumstances apply to one shareholder but not the other:

•            some shares are pre-CGT (acquired before 20 September 1985)

•            non-resident

•            cost base of a share isn't substantially less than the capital benefit's value

•            net capital loss for the income year

•            private company that wouldn't have been entitled to a rebate under former section 46F (which excluded 'exempting entities'[21])

•            tax losses.

We don't think section 45A applies because Noteholders won't be 'advantaged shareholders' in the relevant sense.

96.       Noteholders won't be 'advantaged shareholders' in the sense of subsection 45A(1). The ruling scheme doesn't disclose any circumstances suggesting that the Noteholders will have different characteristics to Company A's shareholders in any of the listed circumstances in subsection 45A(4), or in any other circumstance that would give them a greater benefit from capital benefits.

97.       Since Noteholders won't be 'advantaged shareholders', it follows that section 45A won't apply to the scheme.

Question 6

Will section 45B apply in relation to a redemption of Notes such that the Commissioner will make a determination under subsections 45C(1) or 45C(3) in relation to the ruling scheme?

Answer

No

Summary

98.       Section 45B is an integrity rule applying to schemes providing capital benefits that are entered into for a non-incidental purpose of obtaining a tax benefit.

99.       On the facts and circumstances of this scheme, we don't think that any of the relevant parties have a more than incidental purpose of getting a tax benefit.

100.    Since the purpose requirement isn't met, section 45B doesn't apply.

Detailed explanation

Section 45B applies to schemes providing capital benefits that are entered into for a more than incidental purpose of obtaining a tax benefit.

101.    Section 45B is an integrity rule applying to schemes that provided capital benefits, entered into for a non-incidental purpose of obtaining a tax benefit.

102.    The objects clause in subsection 45B(1) relevantly says the provision treats amounts as dividends if they are made in substitution for dividends.

103.    Section 45B applies where three conditions in subsection 45B(2) are met:

•            there's a scheme under which a person is provide with a demerger or capital benefit

•            a taxpayer obtains a tax benefit

•            having regard to the relevant circumstances of the scheme, it would be concluded that a person who entered into or carried out the scheme did so for a purpose (which need not be dominant but doesn't include an incidental purpose) of enabling a taxpayer to obtain a tax benefit.

104.    Subsection 45B(3) says that where section 45B applies, the Commissioner may make a determination that section 45C applies to the capital benefit.

105.    Other subsections in section 45B explain some of the terms used in subsection 45B(2).

•            Subsection 45B(5) says 'provided with a capital benefit' includes the provision of ownership interests in a company, the distribution of share capital or share premium, or something done (in relation to an ownership interest) that has the effect of increasing the value of an ownership interest.

•            Subsection 45B(7) says a distribution to an entity holder is taken to be a distribution to the equity holder of share capital to the extent it's a non-share capital return.

•            Subsection 45B(8) lists 'relevant circumstances of the scheme' for determining the scheme's purpose. Without listing them in full, they include the tax characteristics (residency, capital losses etc.) of the taxpayer, the form and substance and manner carried out of the scheme.

•            Subsection 45B(9) says a taxpayer obtains a 'tax benefit' if an amount of tax payable would be less than the amount that would have been payable if the capital benefit had been an assessable dividend.

We don't think the facts and circumstances of the scheme suggest the parties have a more than incidental purpose of getting a tax benefit.

106.    Now we apply the conditions in subsection 45B(2) to the circumstances of the scheme.

107.    The Issue Price component of the Redemption Price is a capital benefit. If Notes are treated as shares for tax purposes, then the Issue Price would be a return of share capital (see paragraph 95). However, if they aren't, the notes would be a distribution of non-share capital. In that case, the distribution would be a non-share capital return, and deemed to be a capital benefit under subsection 45B(7). The condition in paragraph 45B(2)(a) is met.

108.    A taxpayer will also obtain a tax benefit. If section 45B doesn't apply, the Issue Price component of the Redemption Price will be treated as a tax-free return of capital to the Noteholders. The Noteholders would pay more tax if it were taxable instead as a dividend. The condition in paragraph 45B(2)(b) is met.

109.    But we don't think any relevant party had a non-incidental purpose of getting a tax benefit. The Noteholders contribute capital when subscribing and get a redemption payment on redeeming. The Redemption Price is only treated as a capital return to the extent of the Issue Price, and any excess is taxed as a dividend. We don't see that avoiding tax on the capital component could be anything other than an incidental purpose. It follows the conditions in paragraph 45B(2)(c) aren't met.

110.    Since the condition in paragraph 45B(2)(c) isn't met, it follows that section 45B doesn't apply to the scheme.

Question 7

Will the commercial debt forgiveness rules in Subdivisions 245-C to 245-G apply to Company A in respect of any Notes that are redeemed for a Redemption Price that is less than the Issue Price of the Notes?

Answer

No

Summary

111.    The commercial debt forgiveness rules won't apply because redemption for less than the Issue Price doesn't amount to a forgiveness event for the purposes of Division 245.

Detailed explanation

Division 245 won't apply because there's no event that would amount to debt forgiveness for tax purposes.

112.    Division 245 contains the debt forgiveness rules.

113.    Very broadly, where the debt forgiveness rules apply, the forgiven amount (calculated under Subdivisions 245-B and 245-C) is applied to reduce tax and capital losses, certain deductible expenditure, and cost base for CGT assets (see Subdivision 245-E).

114.    Broadly, section 245-10 says that the rules in Subdivision 245-C to 245-G apply to a debt if you:

•            can deduct interest on the debt

•            could have deducted interest on the debt had interest been payable

•            interest on the debt could have been deducted but for the operation of a provision of this Act, apart from the first three negative limbs of section 8-1.[22]

115.    While interest isn't payable under the scheme, Division 245 could nevertheless apply if interest on the debt could have been deductible if payable.

116.    A debt is forgiven for Division 245 purposes if:

•            the debtor's obligation to pay is released or waived, or is otherwise extinguished other than by repaying the debt in full: paragraph 245-35(a)

•            the debt becomes statute barred: paragraph 245-35(b)

•            the creditor assigns the right to receive payment to another entity in certain ways (broadly about non-arm's lengths dealings): section 245-36

•            an entity subscribes for shares and the debtor applies the subscription money to pay its debt: section 245-37.

117.    The scheme doesn't amount to debt forgiveness. Company A has an obligation to pay a debt to the Noteholder when either party elects to redeem a Note. That debt is extinguished by repaying the debt in full on redemption. This doesn't change if the Redemption Price is less than the Issue Price, because the Noteholder only becomes entitled to the Redemption Price on redemption as worked out under the terms of issue. (The Noteholder isn't releasing part of a debt that was already owing). Further, nothing becomes statute barred, there's no assignment, and there's no set-off against an obligation to subscribe for shares. (If the Notes are shares, then they've been fully paid on subscription).

118.    Since the scheme doesn't amount to debt forgiveness, the debt forgiveness rules in Division 245 won't apply.

119.    We won't address whether interest would have been deductible if payable because Division 245 wouldn't apply in any event.

Question 8

Will a gain or profit that is assessable to Company A under section 6-5 arise as a consequence of the issue or redemption of Notes?

Answer

No

Summary

120.    No amount will be assessable as ordinary income to Company A under section 6-5 because Company A won't have a real gain from issuing or redeeming the Notes.

Detailed explanation

Company A won't have amounts assessed as ordinary income because it isn't making a gain. It receives the subscription proceeds from the Noteholder as an investment of capital, and hasn't gained on redemption because it returns all proceeds to the Noteholder.

121.    Section 6-5 says your assessable income includes ordinary income.

122.    We'll cite an academic text as authority for two propositions about ordinary income. In Income Taxation in Australia,[23] Parsons says:

•            to have the character of income, an item must be a gain by the taxpayer who derived it [2.38-2.40]

•            there's no gain if an item is derived by the taxpayer as a contribution to capital, including where a company receives payments for subscription for shares or debentures [2.113-2.131].

123.    There's an ATO ATOID about buying back Notes. ATO ID 2011/100[24] said gains made by a financial institution from buying back its own Notes at a discount to their face value were assessable income under section 6-5. The ATO ID reasoned that income from carrying on business is generally ordinary income, and a financial institution is in the business of borrowing, lending, and repaying borrowed funds.

124.    We don't think any amounts could be assessable to Company A as ordinary income.

•            On subscription, Company A receives the Issue Price as a contribution of capital. Company A invests those funds until redemption. There's no gain as it's merely a contribution of capital.

•            On redemption, Company A releases cash equal to the value of its obligation to pay the redeeming Noteholder (equal to the value of the investments purchased with the Issue Price).

•            There's a notional gain if the Redemption Price is less than the subscription proceeds (because the Note Portfolio has declined in value).

•            However, we don't think there's a real gain that would be caught by section 6-5. The terms of these Notes effectively quarantine the Note Portfolio to be set aside for redemption payments, so Company A isn't profiting in a real sense.

•            Unlike the financial institution in ATO ID 2011/100, Company A isn't carrying on a business of borrowing and lending, so it won't make any gain or loss in the ordinary course of trading.

125.    We conclude that the issue or redemption of Notes won't result in any amounts that are assessable to Company A under section 6-5.

Question 9

Does the issue or redemption of Notes give rise to CGT event D1 for Company A pursuant to section 104-35?

Answer

No on issue.

Yes on redemption, but the notional CGT event won't result in a capital gain.

Summary

126.    CGT event D1 happens if you create a contractual right or other legal right in another entity, unless it falls within an exception, one of which is for issuing an equity interest.

127.    CGT event D1 won't happen on issuing the Notes, because it fits within an exception for issuing an equity interest.

128.    CGT event D1 will happen on redemption, but the CGT event won't result in a capital gain because Company A won't receive money or property from the event.

Detailed explanation

CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity, unless an exception applies.

129.    Subsection 104-35(1) says CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity.

130.    However, subsection 104-35(5) says CGT event D1 doesn't happen if any of a list of exceptions apply, including (c), where a company issues or allots equity interests or non-equity shares in the company.

131.    Section 995-1 says equity interest, for a company, has the meaning given by Subdivision 974-C.

132.    Subsection 104-35(3) says you make a capital gain if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event.

133.    Section 116-20 says the capital proceeds from a CGT event are the money and market value of property you received (or are entitled to receive) in respect of the event happening.

134.    Section 110-35 says incidental costs include remuneration for professional services, transfer costs, stamp duty, advertising/marketing, valuation costs, search fees, conveyancing costs, and borrowing expenses.

CGT event D1 won't happen on issuing the Notes because it falls within the exception in paragraph 104-35(5)(c) for issuing equity interests.

135.    Subsection 104-35(1) is met on issuing the Notes because Company A creates a right (contractual or legal) in the Noteholder to redeem the Notes.

136.    However, the exception for issuing equity interests is met on issuing the Notes. We concluded at Question 1 that the Notes were classified as equity interests for Division 974 purposes. Therefore, issuing the Notes amounts to issuing equity interests in Company A and paragraph 104-35(5)(c) applies to prevent CGT event D1 happening.

CGT event D1 happens on Redeeming the Notes because it doesn't fall within that exception.

137.    Subsection 104-35(1) will also be met on redeeming the Notes. If Company A elects to compulsorily redeem the Notes, it creates a right in the Noteholder to be paid the Redemption Price. That right doesn't exist before either party decides to redeem under the issue terms.

138.    The exception in subsection 104-35(5)(c) - issuing an equity interest - doesn't extend to redeeming that equity interest.

139.    None of the other exceptions in subsection 104-35(5) are relevant here.

140.    However, we don't think there's any capital gain. The capital proceeds from triggering the compulsory redemption would be nil as Company A doesn't receive money or property when it redeems the Notes.

Question 10

Will Company A be required to recognise gains and losses under Division 230 in relation to the issue or redemption of the Notes?

Answer

No

Summary

141.    Broadly, the taxation of financial arrangements (TOFA) rules in Division 230 assess gains and allow deductions for losses from some financial arrangements.

142.    If an arrangement is covered by the TOFA rules, you apply one of two default methods to calculate the gain or loss (the accruals and realisation methods), unless you elect to apply an alternative method.

143.    The TOFA rules have a limited operation to financial arrangements that are equity interests. The default methods don't apply to financial arrangements under section 230-50 (about equity interests).

144.    Company A's Notes qualify as equity financial arrangements under section 230-50 because they are classified as equity interests for tax purposes.

145.    Company A won't be required to recognise gains and losses under Division 230 because the default rules don't apply and Company A hasn't elected to use an alternative method.

Detailed explanation

146.    The TOFA rules in Division 230 recognise gains and losses from financial arrangements, treating gains as assessable income and losses as deductions.

147.    Division 230 works like this.

•            Division 230 may apply if you have a financial arrangement under either section 230-45 (about cash settlable financial arrangements) or section 230-50 (about equity interest financial arrangements).

•            Alternatively, Division 230 will apply if you are treated as having a financial arrangement under the extended rules in Subdivision 230-J (foreign currency, non-equity shares, and commodities held by traders).

•            There are exceptions in Subdivision 230-H, broadly for short-term non-money arrangements, and short-term arrangements involving entities with particular characteristics.

•            If Division 230 applies, you work out the gain or loss under rules in Subdivision 230-B through Subdivision 230-F. Broadly, if the gain or loss is sufficiently certain when you enter an arrangement, then you apply the accruals method. Otherwise, the realisation method applies by default. You may choose to apply other calculation methods (in Subdivisions 230-C through 230-F).

Is there a financial arrangement under section 230-45? Yes, because the entities have rights to receive and give financial benefits under the scheme.

148.    Subsection 230-45(1) says you have a financial arrangement if you have, under an arrangement, a cash settlable legal or equitable right to receive, or obligation to provide, a financial benefit, or a combination of both, unless you also have a right to receive or obligation to provide something that isn't a financial benefit or isn't cash settlable, and it isn't insignificant.

149.    Paragraph 230-45(2)(a) says that a financial benefit is cash settlable if it's money or a money equivalent.

150.    Section 974-160 says 'financial benefit' means anything of economic value and includes property and services.

151.    The arrangement is a financial arrangement under section 230-45.

•            On issuing the Notes Company A has a right to receive the Issue Price (receive money).

•            On redeeming the Notes Company A has an obligation to pay the Redemption Price (pay money).

•            While Company A may choose to meet the obligation by transferring assets, the Noteholder may insist on receiving cash, so we think it's still cash settlable.

•            Both are financial benefits and both are cash settlable (money has economic value).

•            There are no non-cash settlable, non-financial benefits under the scheme, unless Company A chooses to transfer assets instead.

Is there a financial arrangement under section 230-50? Yes, because the scheme involves equity interests, and we think section 230-50 covers the issuer as well as the holder.

152.    Section 230-50 is about equity interests and rights or obligations about equity interests.

153.    Subsection 230-50(1) says you have a financial arrangement if you have an equity interest, and the equity interest constitutes the financial arrangement.

154.    Subsection 230-50(2) says you have a financial arrangement if you have a right to receive or provide something that's a financial arrangement under this section, and that right or obligation isn't part of a financial arrangement under section 230-45.

155.    The 'accruals' and 'realisation' methods don't apply to 'equity' financial arrangements under section 230-50: see paragraph 230-40(4)(e).

156.    TD 2011/12[25] says that where an equity interest is a financial arrangement under both subsections 230-45(1) and 230-50(1), section 230-50 prevails.

157.    However, while subsection 230-50(1) prevails over section 230-45, presumably section 230-45 still prevails over subsection 230-50(2) given the express statement in paragraph 230-50(2)(b).

158.    The Explanatory Memorandum[26] to the bill introducing the TOFA provisions makes the following points.

•            Equity interests that are financial arrangements are only subject to either the elective fair value method or the election to rely on financial reports and in limited circumstances the elective tax hedge method. [2.12]

•            Equity interests, including rights to receive, and obligations to provide, equity interests, are a separate category of financial arrangement, but gains and losses are only subject to Division 230 in limited circumstances. [2.28 and 2.40]

•            Equity interests are treated as financial arrangements under subsection 230-50(1) even if they are cash settlable financial arrangements under section 230-45, and will be subject to the limited scope of Division 230. [2.102]

159.    The phrase 'have an equity interest' in subsection 230-50(1) isn't defined.

160.    We've consulted other sources about the meaning of 'have'.

•            The Macquarie Dictionary[27] lists the first meaning of 'have' as a verb meaning 'to possess; own; to hold for use', and it gives 'to have property' and 'to have a car' as examples.

•            One meaning given by the Australian Oxford Dictionary[28] is 'to hold in possession as one's property or at one's disposal; be provided with' (as in 'has a car', 'has no time to read')

•            However, the Australian Oxford Dictionary gives another meaning as 'contain as a part or quality' (as in 'house has two floors').

•            An example of a similar use is in the Small Business Guide in the Corporations Act 2001 (In Part 1.5). At 6.2 the Guide says "A company may have different classes of shares."

•            The Oxford Dictionary of English[29] also gives consistent meanings. One meaning is 'possess, own, or hold' ('he had a new car and a boat'), but another is 'be made up of; comprise' ('the party had 10,000 members').

161.    There's an interpretive question here about whether subsection 230-50(1) covers the issuer of an equity interest or is restricted to an entity holding or owning the relevant equity interest.

•            The most common ordinary meaning given by the dictionaries listed above is 'own/possess/hold'.

•            That would imply only the holder or owner of the shares would have the equity interest, excluding the entity issuing the equity interest.

•            An entity that has issued equity interests doesn't own or possess shares in itself.

•            However, another possible meaning is 'comprise'. An entity might be 'comprised' of equity interests, in the sense of a party being comprised of members (as in the Oxford Dictionary of English example), or a company being comprised of shares (as in the Corporations Act's Small Business Guide example).

•            In that second sense, an entity might 'have' equity interests if its ownership structure consists of members in the entity who own or hold membership interests in it.

162.    Provisions elsewhere in the TOFA rules exclude equity financial arrangements from certain elections. Subsection 230-225(1) says that a fair value election doesn't apply to a financial arrangement if:

•            the arrangement is an equity interest, and

•            you are the issuer of the equity interest.

Subsection 230-415(1) has an identical exclusion for elections to rely on financial reports.

163.    The same Explanatory Memorandum[30] gives a paraphrased explanation of this requirement consistent with the legislation. At paragraph 2.108, it says that equity financial arrangements are only subject to these elections (fair value or relying on financial reports) in limited circumstances. It will be subject to these elections where:

•            the taxpayer is required by accounting standards to classify the arrangement at fair value through profit and loss, and

•            where the financial arrangement is an equity interest, the taxpayer isn't the issuer of the interest.

164.    These exclusions suggest it's possible for an entity to have an equity financial arrangement where it issued the equity interest and doesn't hold or own it. The exclusions for fair value and relying on financial reports in subsections 230-225(1) and 230-415(1) cover financial arrangements where the arrangement is an equity interest, and you issued it. These exclusions seem to be directed at equity financial arrangements under subsection 230-50(1) rather than subsection 230-50(2). Subsection 230-50(1) says the equity interest constitutes the financial arrangement, while subsection 230-50(2) is about rights to acquire equity interests (e.g. options). In the later case, the financial arrangement would be a right over the equity interest, not the equity interest as such. Therefore, the election exclusions in subsections 230-225(1) and 230-415(1) seem to contemplate that the issuer of an equity interest would be covered by subsection 230-50(1). If the issuer wasn't covered, these exclusion provisions would be unnecessary.

165.    Considering these materials, we think a broader meaning of 'have' that includes 'comprises' is appropriate here. The dictionary and Corporations Act Small Business Guide usages we've cited show it's possible to speak of an entity 'having' interests that make up its ownership structure. (That is, a company can 'have' shares it issued, or a unit trust can 'have' units it issued.) This interpretation avoids making the election exclusions in subsections 230-225(1) and 230-415(1) redundant, and seems consistent with the Explanatory Memorandum passages suggesting equity interests should only be covered by the TOFA rules in limited circumstances.

166.    This means Company A's Notes are equity financial arrangements. We've ruled that Company A's Notes are equity interests. Given our interpretation that 'you have an equity interest' covers the issuer of an equity interest, Company A 'has' equity interests because it issued the Notes. Therefore, Company A's Notes are covered by subsection 230-50(1).

167.    It follows that the tax treatment of Company A's Notes won't be determined under Division 230. Since Company A's Notes are equity financial arrangements under section 230-50, paragraph 230-40(4)(e) excludes the accruals and realisation methods from applying to gains and losses from the arrangement. Company A would only be covered by the TOFA rules if it made a valid election[31] to use another method. Since Company A hasn't elected to use another method, it won't be covered by the TOFA rules.

Conclusion on Question 10: the TOFA rules in Division 230 won't apply to Company A's Notes.

168.    We conclude that the tax treatment under the TOFA rules in Division 230 won't apply to Company A's Notes. Company A's Notes qualify as equity financial arrangements under section 230-50. Section 230-50 arrangements are excluded from the default TOFA methods (accruals and realisation). Since Company A hasn't elected to use an alternative method, gains or losses won't be dealt with under Division 230.

Question 11

Are the Notes 'traditional securities' as defined in section 26BB?

Answer

No

Summary

169.    Broadly, section 26BB defines traditional securities as securities that either 1) don't have an eligible return, or 2) have an ascertainable eligible return that's less than an amount determined under a specified formula.

170.    In this context:

•            'securities' is defined to mean a list of items like stocks, debentures, bonds, loans, and other contracts, and

•            a security has an 'eligible return' if, when issued, having regard to terms, it's reasonably likely that the return will exceed the Issue Price.

171.    The ATO view (in TR 96/14[32]) is 'securities', given the nature of terms in the expanded definition, means investments that have debt like characteristics.

172.    We don't think Company A's Notes are 'securities' because they have an equity rather than a debt character, so they don't qualify as 'traditional securities'.

173.    If we're wrong about this point, and Company A's Notes do qualify as 'securities', we still don't think they meet the definition of traditional securities. Our view is that Company A's Notes do have an eligible return because we think it's reasonably likely, based on the terms of issue, that the Redemption Price will exceed the Issue Price. However, the amount of that eligible return can't be precisely ascertained. Therefore, Company A's Notes, if securities, don't fall within either limb of the definition in section 26BB.

Detailed explanation

'Traditional securities' are securities that either 1) don't have an eligible return, or 2) have an ascertainable eligible return that doesn't exceed a prescribed amount.

174.    Section 26BB says 'traditional security' means a security held by a taxpayer that 1) is or was acquired by the taxpayer after 10 May 1989, 2) isn't trading stock, and 3) either:

•            it doesn't have an eligible return, or

•            it has an eligible return, where:

o   the precise amount of the eligible return is able to be ascertained at the time of issue of the security, and

o   the amount isn't greater than 1.5% of the amount calculated under the formula Payments * Term.

(Payments = the amount of the payment or of the sum of the payments (excluding any periodic interest) liable to be made under the security when held by any person)

(Term = the number, including any fraction, of years in the term of the security)

175.    Two of the conditions for a traditional security are met because the Notes will be acquired after 10 May 1989 and aren't trading stock.

176.    Therefore, to qualify as a 'traditional security' we need to apply the definitions of 'security' and 'eligible return'.

The ATO view is that 'security', in this context, broadly means an interest carrying a debt-like obligation.

177.    Subsection 159GP(1) says 'security' means:

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

•            b) a deposit with a bank or other financial institution

•            c) a secured or unsecured loan

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

178.    Section 6 says 'debenture' in relation to a company, includes debenture stock, bonds, notes, and any other securities, whether constituting a charge on the assets of the company or not.

179.    Many of the other terms in these definitions ('stock', 'debenture stock', 'bond', 'note', 'promissory note', 'loan') aren't defined.

180.    We've consulted the Macquarie Dictionary, Australian Oxford Dictionary, and Investopedia for guidance about the meaning of these terms in financial contexts.[33]

•            'Stock' usually means shares in a company, but according to the Australian Oxford Dictionary it can also mean money lent to a government at fixed interest.[34]

•            According to the Macquarie Dictionary, 'debenture stock' means a total amount borrowed from a number of lenders but treated as a single stock rather than separate loans, while Investopedia says debenture stocks are a type of equity security that act more like a preferred stock than a bond.[35]

•            'Bond' is an instrument or certificate with a fixed-term that repays the principal at maturity, usually with additional interest payments at specified intervals.[36]

•            A 'bill of exchange' is a written order to pay a specified sum on a specified date.[37]

•            'Note' means a document that acknowledges a debt and promises payment to the holder.[38]

•            'Promissory note' is a written promise to pay a specified sum of money to a specified person or to the bearer, at a fixed time or on demand.[39]

181.    In a different context, TR 92/11[40] at paragraph 12 says the essential character of a loan is the lender's entitlement to repayment, at some time in the future, of the property lent.

182.    An ATO ruling addresses the meaning of 'security' in this context. TR 96/14, about 'traditional securities' in section 26BB, discusses the definition of 'security' in subsection 159GP(1). It makes the following points.

•            Paragraph (a) of the definition includes securities that are generally recognised as debt instruments. [4](i)

•            The ATO view is that the term 'or other security' in paragraph (a) of the definition, in this context, only encompasses instruments that evidence an obligation for the issuer to pay an amount to the holder, whether during the instrument's term or on maturity. [29]

•            The types of securities mentioned in paragraph (a) will generally be recognised as debt instruments. [29]

•            Only contracts that have debt like obligations will usually fall under paragraph (d) of the definition. [4](i) and [30]

183.    An ATO Interpretative Decision addressed the definition of 'security'. ATO ID 2010/17[41] was about investors subscribing for units in a unit trust, where the unit trust lent the subscription funds to allow another entity to buy real property. At the end of the loan's 10-year term the borrower was required to pay the unit trust 80% of the adjusted net sales value of the real property. The ATO decided that the loan was a 'security' because the instrument (following TR 96/14) evidenced an obligation to pay an amount on maturity. The fact that the amount ultimately paid couldn't be calculated until maturity was irrelevant.

184.    PS LA 2001/8[42] makes the following points about ATO IDs.

•            ATO IDs are a summarised version of a decision we've made on how the law applies to a particular situation.

•            ATO IDs set out a precedential ATO view.

•            ATO officers must follow an ATO ID where 1) in the officer's judgment, there's no material difference between the facts of the issue the officer is making a decision on and the facts of an existing ATO ID, and 2) the officer is satisfied that the application of the precedential ATO view set out in the ATO ID will result in a correct decision.

185.    Consistent with ATO guidance in TR 96/14, we will interpret the elements of the definition to mean types of securities usually recognised as debt instruments.

•            While 'stock' could potentially mean shares, we think in this context it refers to money lent to the government at interest.

•            'Debenture stock' refers to a sum borrowed from several lenders, in the sense of the Macquarie Dictionary definition.

186.    Company A's Notes don't qualify under the definition in subsection 159GP(1).

•            Company A's Notes aren't 'stock' in the sense of money lent to a government.

•            While Company A's Notes are called 'notes', we think 'notes', in the context of the 'debenture' definition, means an obligation to repay a specific amount, as in a principal sum.

•            Company A's Notes aren't notes in the sense used in the 'debenture' definition, or bonds, bills of exchange, or promissory notes, because they don't carry an obligation to repay a principal sum at a specified time.

•            Company A's Notes don't qualify as 'or other securities' in the paragraph (a) sense, because they aren't 'debt like': the amount of the payment will be a proportion of the Note Portfolio value, rather than a repayment of the face value of the subscription amount, suggesting the Note has more of an equity character.

•            Company A's Notes aren't loans under paragraph (a) for similar reasons. Loans are agreements to repay a principal sum plus interest. Here, Company A's obligation to repay is determined by the value of the Note Portfolio rather than repayment of the subscription amount.

•            Since Company A's Notes have an equity character, they don't qualify as 'any other contract' under paragraph (d).

187.    We've decided ATO ID 2010/17 doesn't apply.

•            The scheme and issue is similar because both ATO ID 2010/17 and this ruling scheme are about arrangements where the investing entity will receive a return based on the value of the relevant property portfolio on maturity.

•            However, the facts aren't identical. ATO ID 2010/17 concerned an instrument described as a 'loan' to another entity that would buy real property, where the instrument had a fixed term of 10-years, and the return price would be 80% of the expected sale value. In contrast, Company A's Note Portfolio includes mixed asset classes including shares, and the term is indefinite.

•            We think those are significant differences that may make the arrangement in ATO ID 2010/17 somewhat more 'debt like'. We think real property is significantly more likely to either retain value or appreciate over a 10-year period than many other investments. It's possible that 80% of the expected sale value over a 10-year period, in many cases, would approximate the return on a debt-like instrument (e.g. face value plus interest over 10 years).

•            We're not confident that following the decision in ATO ID 2010/17 would result in a correct result in this case. The return payment is fixed by the value of the Note Portfolio, and that value could have little or no correlation to the subscription amount. While we think there's a significant chance of a positive return (see Question 11 at paragraphs 218 to 221), risk and fluctuations on a mixed asset portfolio could be greater than an investment in real property alone. We think it's possible that the Noteholder would carry the risk and rewards normally associated with an equity interest to a greater extent than the creditor in ATO ID 2010/17.

•            Given those concerns, we think we're acting consistently with PS LA 2001/8 in not following ATO ID 2010/17.

188.    Since we've decided that Company A's Notes don't qualify as a security, they can't be a traditional security under section 26BB.

189.    However, if we're wrong about this point, we've also considered whether the Notes, if they do qualify as a security, would meet the remaining requirements of a traditional security.

Whether the Notes will have an eligible return depends on whether it's reasonably likely that the Redemption Price will exceed the Issue Price.

190.    Subsection 159GP(3) says there's an eligible return if, when the security is issued, it's reasonably likely (by reason that the security was issued at a discount, bears deferred interest or is capital indexed, or for any other reason), having regard to the terms of the security, for the sum of all payments (other than periodic interest payments) under the security to exceed the issue price of the security, and the amount of the eligible return is the amount of the excess.

191.    Since the only amount payable under the terms of the Notes is the Redemption Price, there will be an eligible return if, on issue, it's reasonably likely that the Redemption Price is more than the Issue Price.

192.    Is it 'reasonably likely' that the Redemption Price will exceed the Issue Price?

193.    To answer this question, we need to consider two things. First, what standard does the phrase 'reasonably likely' set in this context? Second, does the likelihood (that the Redemption Price exceeds the Issue Price) meet that standard?

What standard does the phrase 'reasonably likely' set in this context? We think it means more likely than not but short of near certainty.

194.    'Reasonably likely' isn't defined.

195.    Undefined terms usually take their ordinary or legal meaning considering the statutory context.[43]

196.    We've consulted the Macquarie Dictionary for meanings for 'reasonable' and 'likely'.

•            Meanings for 'reasonable' include 'agreeable to reason or sound judgement' or 'not exceeding the limit prescribed by reason; not excessive'.[44]

•            Meanings for 'likely' include 'probably or apparently going or destined (to do, be, etc)' or 'seeming like truth, fact, or certainty, or reasonably to be believed or expected; probable;'.[45]

197.    But dictionaries don't dictate meaning. Pearce's Statutory Interpretation in Australia cites cases cautioning against mechanically applying dictionary definitions in a statutory context. To loosely paraphrase, a dictionary can only illustrate a range of possible meanings of a word; it can't determine the precise meaning of a word in a particular context. Looking up (and applying) the meanings of individual words used in a compound phrase is also dangerous, as the phrase may acquire a special meaning distinct from the component parts.[46]

198.    ATO guidance addresses the meaning of this phrase in a different context. TR 2005/20[47] discusses 'reasonably likely' in Division 240, about sale and loan arrangements. At paragraph 27, it cites a judicial statement to the effect that the meaning of the phrase 'reasonably likely', in ordinary use, speaks of a chance of an event occurring which is real, not fanciful or remote. At paragraph 29, it says in the Division 240 context, 'reasonably likely' means the relevant entity has a future expectation based on a reasonable basis.

199.    Is there anything in the section 159GP context that would affect that meaning or give it a different meaning?

•            The context is Division 16E, about the accruals assessability of certain security payments, is broadly about technical financial concepts.

•            Section 159GP says we must have regard to the terms of the security in determining whether the 'reasonably likely' standard is met, with possible relevant considerations being whether the security was issued at a discount, bears deferred interest,[48] is capital indexed,[49] or for 'any other reason'.

•            A holder of a security issued at a discount (meaning less than the face value) would necessarily receive a principal repayment on maturity more than their original investment.

•            A holder of a security bearing deferred interest would necessarily receive total payments (principal plus deferred interest) exceeding the original investment (principal alone).

•            A holder of a security that's capital indexed (where the principal sum and interest payments appreciate in line with inflation) would expect that they would get a return more than their original investment if they hold it to maturity, barring the risk of persistent deflation during the term. (We think that risk is so remote it can be ignored.)

•            The first two examples are certainto get a return assuming the other party complies, and the third example is almost certain to get a return (a very remote risk of failing to get a return).

•            Arguably the context of those examples give 'reasonably likely' a very high threshold, perhaps close to certainty.

200.    The explanatory materials might suggest a high threshold too. The Explanatory Memorandum[50] to the bill that introduced section 159GP said that a security will have an eligible return if the return will exceed its issue price:

(d) the security must have an "eligible return", which is defined in proposed sub-section 159GP(3). Briefly, a security will be taken to have an "eligible return" if the sum of the payments (other than payments of periodic interest) to be made under the security will exceed its issue price; and

(e) where it is possible to calculate the precise amount of the eligible return at the time the security is issued, the amount of the eligible return must exceed 1.5% of the result obtained by multiplying the sum of the payments (other than periodic interest) by the term, in years and any fraction of a year, of the security. It is expected that this calculation will be used only for fixed return securities (as defined);....

201.    But we don't see that the examples or the Explanatory Memorandum comments are enough to give it such a high standard. 'Reasonably likely' doesn't mean 'near certainty' in general usage. The examples are followed with 'or for any other reason', suggesting they are just roughly illustrative. The drafter could have chosen stronger words ('reasonably certain', 'probable', or 'highly likely') to achieve that effect. The comments in the Explanatory Memorandum could be read as either 1) an illustrative example of something that would be covered, or 2) a reference to the outcome rather than probability (i.e., the probability is still just 'reasonably likely' while 'will exceed' is the outcome rather than the chance of getting a particular outcome). In any case, words in the Explanatory Memorandum don't override words used in the provision, and the provision here doesn't say "will exceed".

202.    The applicant has submitted that the phrase 'or for any other reason' should be interpreted narrowly in this context. The applicant says it is a phrase using general words, which should be confined to things of the same class as the preceding part of the sentence following the 'ejusdem generis' maxim. It suggests that the three listed phrases (issued at a discount, bears deferred interest, or is capital indexed) fall within a class of reasons where the amount of the payment can be reliably predicted. Following the 'ejusdem generis' maxim, the general words at the end of the sentence ('or for any other reason') should be interpreted to mean any reason that would allow the amount of any return to be reliably predicted.

203.    We'll list some propositions from Pearce's text[51] about the 'ejusdem generis' maxim.

•            Pearce describes Latin maxims as syntactical presumptions or semantic rules rather than legal rules. [4.32 at p.165]

•            Pearce argues syntactical presumptions are only aids to understanding a writer's intention, and can be discarded if there's any suggestion that a different meaning was intended. [4.32 at p.165]

•            Ejusdem generis means general matters are constrained by reference to specific matters: a drafter may assume, having indicated the main specific matters in a broad category, that general words will be read down only to cover things falling within that category. [4.34 at p.167]

•            The presumption can't be applied if the listed specific matters don't establish a genus or category. [4.32 at p.168; 4.37 at p.169]

•            Sometimes a general word, such as 'whatsoever', can indicate an intention not to be limited by any class created by the specific words. (e.g. where the specific words are merely examples of the general) [4.38 at p. 170-171; 4.39 at p.171]

•            Courts have sometimes declined to apply the presumption by saying that any restriction on the meaning of general words needs to be justified by the context. [4.41 at pp.172-174]

204.    We don't think the ejusdem generis concept should apply to limit the meaning of eligible return here. We accept that the three listed phrases could be characterised as falling within a narrower class. However, we don't think the construction of the sentence suggests an intention to limit the general phrase to any narrower class.

205.    The first task is to identify whether the three listed phrases fall within a given class.

206.    We disagree with the applicant's submissions about the specific class. The applicant submits that the three specific phrases are all reasons where the amount of the return can be accurately predicted. A security issued at a discount, and a deferred interest security with a specific term, would both have an ascertainable return. But we don't think that applies to a capital indexed security. According to Investopedia, an inflation-indexed security has its principal indexed to the CPI or similar index, to protect both principal and interest payments from inflation.[52] If that's right, then the amount of the return couldn't be predicted until the index for the relevant period had been determined.

207.    However, all three phrases could be characterised as reasons why the holder of the relevant security might be certain (or almost certain) to get a total return exceeding their initial investment as we mentioned in paragraph 200.

208.    If that's a possible class, then the second task is to decide whether the drafter intended to limit the general phrase 'or for any other reason' to that class.

209.    We don't think there's any intention to limit the meaning of the general phrase in that way.

•            The opening phrase sets a standard of 'reasonably likely'.

•            It follows that phrase with three specific reasons that are almost certain to produce a positive return.

•            Then it follows the three specific reasons with 'or for any other reason'.

•            'Or for any other reason' seems a very broad phrase: 'any' wouldn't be needed if it was directed at a specific class of reasons

•            Restricting 'any other reason' to the categories given would suggest the phrase should be interpreted as if it was followed with additional words, e.g. "or for any other reason similar to the ones just specified".

•            We think that narrower reading is inconsistent with the ordinary meaning of 'reasonably likely', effectively removing the phrase and substituting it with a higher standard of 'near certainty'.

•            In contrast, taking a broad reading of 'or for any other reason' allows us to give the phrase 'reasonably likely' its natural meaning: significantly more likely than not to happen but not necessarily complete certainty.

•            Therefore, we don't think the sentence read as a whole shows an intention to limit the meaning of 'for any other reason' to a narrower class of reasons that might resemble the three specific phrases.

•            We think the three specific phrases should be treated as simply illustrating examples of reasons that might be 'reasonably likely' to result in a positive return, rather than implying an extra requirement that any other reasons must fit within a limited class of arrangements that resemble them.

210.    The applicant also submitted that the phrase 'reasonably likely' requires a reasonably reliable prediction about the amount of the payment. It cited ATO ID 2008/42[53] (now withdrawn). That ATO ID, after discussing some case law, said that the 'reasonably likely' threshold would be met where both the following criteria were satisfied:

•            There's a real chance the payment will be made, but not so unlikely that it can be classified as remote or fanciful, and

•            A reasonably reliable prediction can be made as to the amount of the payment.

211.    ATO ID 2008/42 goes on to say a prediction is 'reasonably reliable' where there's a sound and logical basis for making it, for example, because the quantum of the payment is fixed or readily calculable.

212.    We disagree.

•            ATO ID 2008/42 has been withdrawn, and the ATO's withdrawal notice said the Tax Office was reconsidering the position stated. Therefore, we can't rely on the decision or reasoning in ATO ID 2008/42.

•            The suggestion that the 'reasonably likely' threshold requires a reasonably reliable prediction to be made about the amount of the payment appears to have been taken from Federal Commissioner of Taxation v Peabody when addressing the phrase 'reasonably expected' in the general anti-avoidance provisions in Part IVA.[54]

•            We don't see any reason to import an additional standard based on judicial comments addressing a different phrase in a different provision.

•            Further, the interpretation in ATO ID 2008/42 of a reasonably reliable prediction seems inconsistent with the definition of 'traditional security'. A security will be a traditional security under the second limb of that definition if, where it has an eligible return, and the precise amount of the return is able to be ascertained at the time of issue of the security, and the amount isn't greater than a specified amount. If an 'eligible return' necessarily required a reliable prediction about the amount of the return, the requirement that the precise amount of the return must be able to be ascertained would be superfluous in many cases.[55]

•            We also don't see that the trailing words in subsection 159GP(3), 'the amount of the eligible return is the amount of the excess', implies the excess return needed to be certain or exactly quantifiable. It still makes sense to talk of an amount of a return even if that amount isn't presently quantifiable.

213.    To summarise, we're interpreting the eligible return definition this way.

•            'Reasonably likely' in this context means that the holder must have grounds to expect with a reasonable level of confidence that the return will exceed the investment, but not necessarily near certainty.

•            'Or for any other reason' should be read broadly to include any reason that would make it 'reasonably likely' to get that positive return.

•            The three specific phrases are just illustrative examples about what reasons might be 'reasonably likely' to result in a positive return, rather than implying an extra prescription that the relevant 'reasons' must fit within a narrower class.

Based on the terms of the security, do Noteholders have a reasonable expectation that the Repayment Price will be more than the Issue Price?

214.    We now apply our interpretation to Company A's Notes to determine whether it has an eligible return. To repeat, a security has an 'eligible return' if, when the security is issued, it's reasonably likely (by reason that the security was issued at a discount, bears deferred interest or is capital indexed, or for any other reason), having regard to the terms of the security, for the sum of all payments (other than periodic interest payments) under the security to exceed the issue price of the security. (The amount of the eligible return is the amount of the excess).

215.    The Note terms say, in effect, that on redemption, the Noteholder is entitled to a payment based on a proportionate share of the Note Portfolio.

216.    The Note terms also warrant that Company A will invest the Note Portfolio in accordance with the Investment Management Agreement.

•            The Investment Management Agreement requires the Manager to follow an investment strategy. The investment strategy allows it to invest in several asset classes including equities, commodities, futures, options, cash, real estate, and digital assets. The investment objectives say the Manager will aim for a 10-15% return, employing a diversified investment approach across a range of asset classes, and adhering to ESG principles.

•            The Investment Management Agreement also warrants that the Manager will exercise reasonable care over the investments, hold an Australian Financial Services Licence, and have the skill, facilities, capacity, and staff to perform the duties and obligations under the agreement.

217.    Based purely on the Note terms, we think it's reasonably likely that the Noteholder will receive a return more than their initial Note subscription.

•            The Manager warrants that it's qualified and competent to manage investments.

•            The terms require the Manager to take a diversified approach to investment.

•            A diversified portfolio would generally increase in value over time. While any individual investment or particular class of investments may fail based on characteristics peculiar to it (e.g. shares in a single company may fail for poor business performance or exposure to an industry-specific risk) a diversified portfolio would usually track the average market return on the relevant assets.[56] It would be rare for a well-diversified portfolio to decrease in value outside systemic risk events like a general economic downturn or financial crisis.

218.    We can see reasons to reach the alternative view that it's not reasonably likely that the Noteholder will receive a return more than their initial Note subscription.

•            Most investments have some risk, and many investments can fail.

•            A portfolio may have a high risk of losing value if it's overly exposed to certain investments or asset classes.

•            Even a well-diversified portfolio could lose value in an economic downturn.

•            What's 'reasonably likely' and whether something has an eligible return shouldn't vary according to economic conditions: e.g., the same investment shouldn't get different results in an economic crisis.

•            Even normal stock-market fluctuations might cause a fund to lose value over the short-term, and the redemption might happen in the short term (growth in the long run might not line up with the Note term).

•            Even a professional manager might make mistakes or may make calculated investment risks that don't pay off.

•            It shouldn't be necessary to evaluate the fund's investment strategy or the competence of the manager to determine whether the 'reasonably likely' threshold is met. Whether something is a 'traditional security' shouldn't be determined by the personal characteristics of the investment manager.

219.    The applicant has submitted that diversification merely reduces risk and isn't relevant to determining the likelihood of receiving a positive return.

220.    But despite those arguments, we think the standard of 'reasonably likely' is still met.

•            We've reached the view that reasonable likelihood, even in the section 159GP context, doesn't mean near certainty.

•            A Noteholder can reasonably expect growth based on the terms of these Notes. While there's always risk of loss, that risk is reasonably unlikely given the terms of the Notes. Those terms include warranties that the manager is competent, will exercise reasonable care, and will adopt a diversified investment strategy. This assessment doesn't depend on the manager's personal characteristics.

•            As mentioned above, a diversified strategy should reduce non-systemic risk, making the characteristics of individual investments less relevant to determining the likelihood of getting a positive return.

•            Given these terms, we think it's unlikely that the Note Portfolio will lose ground.

221.    Since it's 'reasonably likely' that the return will exceed the Issue Price, this means there's an 'eligible return'.

Is there a traditional security under section 26BB?

222.    To repeat, section 26BB says 'traditional security' means a security held by a taxpayer that 1) is or was acquired by the taxpayer after 10 May 1989, 2) isn't trading stock, and 3) either:

•            it doesn't have an eligible return, or

•            it has an eligible return, where:

o   the precise amount of the eligible return is able to be ascertained at the time of issue of the security, and

o   the amount isn't greater than 1.5% of the amount calculated under the formula Payments * Term.

223.    If the Notes are securities, but we're right in saying the Notes dohave an eligible return, it follows that there's no traditional security. The Notes have an eligible return, but the precise amount of the eligible return isn't ascertainable. Neither alternative of the eligible return requirement in section 26BB is met.

Section 70B deductions for losses on traditional securities aren't available.

224.    Section 70B allows a deduction for a loss on the disposal or redemption of traditional securities.

225.    Since we've concluded Company A's Notes aren't traditional securities, the deduction under section 70B isn't available.

Conclusion: Company A's Notes aren't 'traditional securities' because they aren't securities, and if they were, they would have an eligible return that isn't precisely ascertainable.

226.    We've concluded that the Notes aren't traditional securities for two reasons. First, we don't think the Notes are 'securities' as defined in subsection 159GP(1), so they can't be traditional securities. Second, if we're wrong in concluding that the Notes aren't securities, then we don't think they qualify as traditional securities: while (if securities) they have an eligible return, that eligible return can't be precisely ascertained.

Question 12

Where the Redemption Price for a Note is less than the Issue Price, will the shortfall be a capital loss for the purposes of Part 3-1 for the Investor?

Answer

Yes

Summary

227.                  CGT event C2 will happen on redemption, and Noteholders will have a capital loss if the Redemption Price is less than the Issue Price.

Explanation

CGT event C2 will happen when Notes are redeemed under the scheme: a Noteholders' right to a redemption payment is an intangible asset that ends on redemption.

228.    The CGT rules calculate capital gains and losses from CGT events, offset capital losses against capital gains, any include any net capital gain in assessable income.

229.    Section 108-5 explains CGT assets. Subsection 108-5(1) says a CGT asset is any kind of property, or a legal or equitable right that isn't property. Note 1 says examples of CGT assets include shares in companies, units in a unit trust, debts owed to you, and rights to enforce a contractual obligation.

230.    Subsection 104-25(1) says CGT event C2 happens if your ownership of an intangible CGT asset ends in listed circumstances, including by being redeemed, discharged, or satisfied.

231.    CGT event C2 will happen when a Note is redeemed, either by the Noteholders or Company A. The Noteholder has a right to be paid the Redemption Price on redemption. That right is a CGT asset, either as property or another legal right, and it's intangible because it doesn't have a physical form. That right will end by being redeemed, discharged, or satisfied when the Noteholder returns the Note certificate and Company A pays it the Redemption Price.

Noteholders will have a capital loss if the Redemption Price (being their capital proceeds for redeeming the asset) is less than the Issue Price (being their cost base).

232.    Subsection 104-25(3) says you:

•            make a capital gain (from CGT event C2) if the capital proceeds from the ending are more than the asset's cost base

•            make a capital loss if those capital proceeds are less than the asset's reduced cost base.

233.    Section 116-20 says the capital proceeds from a CGT event are the total of money and market value of property you receive (or are entitled to receive) in respect of the event happening.

234.    Section 110-25 has rules about cost base. The cost base of a CGT asset includes 5 elements. The first element is the total of money you paid, and the market value of property you gave (or are required to pay or give) in respect of acquiring it. Other elements include incidental costs, ownership costs, and certain capital expenditure.

235.    Section 110-55 says reduced cost base includes the same 5 elements as cost base, except that the third element is modified.

236.    Noteholders will have a capital loss from CGT event C2 if they have a shortfall on redemption.

•            The capital proceeds will be the Redemption Price Company A pays the Noteholder on redemption (as money received or entitled to receive in respect of that CGT event).

•            The cost base, or reduced cost base, for the Note will include the subscription proceeds or Issue Price (as money paid to acquire the asset).

•            Therefore, Noteholders will have a capital loss if the Issue Price is less than the Redemption Price.

[1] Explanatory Memorandum (House of Representatives) to the New Business Tax System (Debt and Equity) Bill 2001 at paragraphs [2.178-2.181].

[2] Explanatory Memorandum (House of Representatives) to the New Business Tax System (Debt and Equity) Bill 2001 at paragraph [2.197].

[3] Explanatory Memorandum (House of Representatives) to the New Business Tax System (Debt and Equity) Bill 2001 at paragraph [2.201].

[4] Explanatory Memorandum (House of Representatives) to the New Business Tax System (Debt and Equity) Bill 2001 at paragraph 2.193 and Example 2.22.

[5] Pan Macmillan Australia (2024), The Macquarie Dictionary online, accessed at https://app.macquariedictionary.com.au on 25 November 2024 (entry for 'substantial').

[6] We think the 'reasonably likely' test for an eligible return in subsection 159GP(3) is a lower standard, perhaps more like a balance of probability test: see paragraphs 200 to 214.

[7] Explanatory Memorandum (House of Representatives) to the New Business Tax System (Debt and Equity) Bill 2001 at paragraph 2.7.

[8] Explanatory Memorandum (House of Representatives) to the New Business Tax System (Debt and Equity) Bill 2001.

[9] Taxation Determination TD 2004/83 Income tax: can the assignment of an intra-group debt or income stream to an entity that is not a member of the consolidated group give rise to a debt interest for the head company of the group under Division 974 of the Income Tax Assessment Act 1997?

[10] Self Managed Superannuation Funds Ruling SMSFR 2009/2 Self Managed Superannuation Funds: the meaning of 'borrow money' or 'maintain an existing borrowing of money' for the purposes of section 67 of the Superannuation Industry (Supervision) Act 1993.

[11] Explanatory Memorandum (House of Representatives) to the Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 at paragraph 5.34.

[12] Pan Macmillan Australia (2024), The Macquarie Dictionary online, accessed at https://app.macquariedictionary.com.au/ on 6 December 2024 (entry for 'principal').

[13] Pan Macmillan Australia (2025), The Macquarie Dictionary online, accessed at https://app.macquariedictionary.com.au/ on 14 January 2025.

[14] Explanatory Memorandum (Senate) to the Taxation Laws Amendment Bill (No. 3) 1998 at paragraph 8.76.

[15] Explanatory Memorandum (House of Representatives) to the Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 at paragraph 5.16.

[16] Explanatory Memorandum (Senate) to the Taxation Laws Amendment Bill (No. 3) 1998.

[17] Explanatory Memorandum (Senate) to the Taxation Laws Amendment Bill (No. 3) 1998 at paragraph 8.84.

[18] Taxation Ruling TR 2009/3 Income tax: application of section 177EA of the Income Tax Assessment Act 1936 to non-share distributions on certain 'dollar value' convertible notes.

[19] Pan Macmillan Australia (2024) The Macquarie Dictionary online, accessed 4 December 2024 at https://app.macquariedictionary.com.au/, entry for 'stream'.

[20] Section 975-300 (read with section 6) says 'share capital account' is an account the company keeps of its share capital, or another account where the first amount credited was an amount of share capital. Investopedia says 'share premium' is the excess a shareholder pays over the par value of a company share. See Investopedia (2024) 'Share Premium Account: What It Is, How It's Used, Examples' accessed 4 December 2024 at https://www.investopedia.com.

[21] Broadly, 'exempting entity' means a company owned by non-residents or entities that receive distributions as exempt or non-assessable non-exempt income: section 208-5.

[22] These disallow deductions for capital or private/domestic outgoings, or outgoings relevant to gaining or producing exempt or non-assessable non-exempt income.

[23] Parsons, RW (1985) Income Taxation in Australia, Lawbook Company Limited, Sydney, p.36 [2.38-2.40] and pp. 55-60 [2.113-2.131].

[24] ATO Interpretative Decision ATO ID 2011/100 Income Tax Assessable Income: gain made from the buying of Notes at a discount.

[25] Taxation Determination TD 2011/12 Income tax: where an equity interest is a financial arrangement which satisfies both subsections 230-45(1) and 230-50(1) of the Income Tax Assessment Act 1997, which provision applies?

[26] Explanatory Memorandum (House of Representatives) to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008.

[27] Pan Macmillan Australia (2025), Macquarie Dictionary online, available at https://app.macquariedictionary.com.au accessed on 6 February 2025 (entry for 'have').

[28] Oxford University Press (2004), Australian Oxford Dictionary, 2^nd edn, available at https://www.oxfordreference.com accessed on 6 February 2025 (entry for 'have').

[29] Oxford University Press (2010), Oxford Dictionary of English, 3^rd edn, available at https://www.oxfordreference.com, accessed on 6 February 2025 (entry for 'have').

[30] Explanatory Memorandum (House of Representatives) to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008.

[31] Company A may not be able to validly elect into some methods. For example, the exclusions we've discussed in subsections 230-225(1) and 230-415(1) would prevent Company A electing to use the fair value or relying on financial report methods.

[32] Taxation Ruling TR 96/14 Income tax: traditional securities.

[33] SeePan Macmillan Australia (2025), the Macquarie Dictionary online, accessed at https://app.macquariedictionary.com.au; Oxford University Press (2004), Australian Oxford Dictionary, 2^nd edn, accessed at https://oxfordreference.com; accessed on various dates in February and March 2025.

[34] See also Investopedia (2024) 'Stocks: What They Are, Main Types, How They Differ From Bonds';' 'Shares vs. Stocks: Understanding the Difference'; accessed at https://www.investopedia.com on 24 February 2025.

[35] Investopedia (2022) 'How debenture stocks and regular debentures differ' accessed at https://www.investopedia.com on 24 February 2025.

[36] Investopedia (2022) 'Types of Bonds and How They Work' accessed at https://www.investopedia.com on 24 February 2025.

[37] Investopedia (2024) 'Bill of Exchange: Definition, How It Works, and Examples' accessed at https://www.investopedia.com on 3 March 2025.

[38] Investopedia (Feb 2021) 'Notes as Investment Vehicles, Various Types' accessed at https://www.investopedia.com/terms/n/note.asp on 18 February 2025.

[39]; Investopedia (2024) on 3 March 2025.

[40] Taxation Ruling TR 92/11 Income tax: application of the Division 13 transfer pricing provisions to loan arrangements and credit balances.

[41] ATO Interpretative Decision ATO ID 2010/17 Income Tax Eligible investment business: 'other security' - Division 6C of the Income Tax Assessment Act 1936.

[42] Practice Statement Law Administration PS LA 2001/8 ATO interpretative decisions.

[43] See eg, Taxation Ruling TR 2022/4 Income tax: section 100A reimbursement agreements at paragraph 97; Pearce, D (2019) Statutory Interpretation in Australia, 9^th edn, LexisNexis Australia, [4.11] pp.146-148.

[44] Pan Macmillan Australia (2025), the Macquarie Dictionary online, accessed at https://app.macquariedictionary.com.au/ (entry for 'reasonable') on 15 January 2025.

[45] Pan Macmillan Australia (2025), the Macquarie Dictionary online, accessed at https://app.macquariedictionary.com.au/ (entry for 'likely') on 15 January 2025.

[46] Pearce, D (2019) Statutory Interpretation in Australia, 9^th edn, LexisNexis Australia, [3.33] pp.110-112, and [4.13] at pp. 148-149.

[47] Taxation Ruling TR 2005/20 Income tax: the interaction of deemed ownership under Division 240 of the Income Tax Assessment Act 1997 with the 'holding' rules in Division 40.

[48] According to Investopedia, a 'deferred interest bond' is a debt instrument that pays all of its interest as a lump sum at a later date rather than in periodic increments or coupons. See Investopedia (2022) 'Deferred Interest Bond: What it is, How it Works, Examples' accessed at https://www.investopedia.com/terms/d/deferredinterestbond.asp on 20 January 2025.

[49] According to Investopedia, an 'inflation-indexed security' is a security that guarantees a return higher than the rate of inflation if held to maturity, and says they used by investors seeking safe returns with little or no risk. See Investopedia (2021) 'Inflation-Indexed Security: Meaning, Benefits, Examples' accessed at https://www.investopedia.com on 15 January 2025.

[50] Explanatory memorandum (House of Representatives) to the Taxation Laws Amendment Bill (No. 2) 1986.

[51] Pearce, D (2019) Statutory Interpretation in Australia, 9^th edn, LexisNexis Australia, [4.32-4.39] pp. 165-174.

[52] Investopedia (2021) 'Inflation-Indexed Security: Meaning, Benefits, Examples' accessed at https://www.investopedia.com on 15 January 2025.

[53] ATO Interpretative Decision ATO ID 2008/42 (Withdrawn) Income Tax Shared Equity Agreement: Division 16E of the Income Tax Assessment Act 1936.

[54] Federal Commissioner of Taxation v Peabody (1994) 181 CLR 359.

[55] We concede that they aren't identical tests: a 'reasonably reliable' prediction might in some cases produce an eligible return of an approximate amount but not a precise ascertainable amount.

[56] See generally Pierson et al 2015, Business Finance 12^th edn, McGraw Hill, at 7.5, pages 179-190 and Wikipedia (2025) 'Diversification' accessed at https://en.wikipedia.org/wiki/Diversification on 13 February 2025.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).