Edited version of private ruling

Authorisation Number: 1011678527439

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Ruling

Subject: Income tax implications of variation to funding and dividend arrangements

Question 1

Will an Agreement Loan from the B&C Partnership to A which will be made on a commercial arm's length basis and must be repaid, be treated as debt pursuant to section 974-15 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes, an Agreement Loan from the B&C Partnership to A which will be made on a commercial arm's length basis and must be repaid will be treated as debt pursuant to section 974-15 of the
ITAA 1997.

This ruling applies for the following period/s:

Other/Substituted Accounting Period 1 January 2011 to 31 December 2011
Other/Substituted Accounting Period 1 January 2012 to 31 December 2012
Other/Substituted Accounting Period 1 January 2013 to 31 December 2013
Other/Substituted Accounting Period 1 January 2014 to 31 December 2014
Other/Substituted Accounting Period 1 January 2015 to 31 December 2015

The scheme commences on:

1 January 2006

Question 2

Will a Funding Loan made after 31 December 2010 from the B&C Partnership, which will be made on a commercial arm's length basis and must be repaid, be treated as debt pursuant to
section 974-15 of the ITAA 1997?

Answer

Yes, a Funding Loan made after 31 December 2010 from the B&C Partnership, which will be made on a commercial arm's length basis and must be repaid will be treated as debt pursuant to
section 974-15 of the ITAA 1997?

This ruling applies for the following period/s:

Other/Substituted Accounting Period 1 January 2011 to 31 December 2011
Other/Substituted Accounting Period 1 January 2012 to 31 December 2012
Other/Substituted Accounting Period 1 January 2013 to 31 December 2013
Other/Substituted Accounting Period 1 January 2014 to 31 December 2014
Other/Substituted Accounting Period 1 January 2015 to 31 December 2015

The scheme commences on:

1 January 2006

The scheme that is the subject of the ruling:

1. Several years ago, A, B, C, D and the B&C partnership entered into a funding agreement (the Agreement). The terms of this agreement was central to the original ruling request issued several years ago.

2. Further ruling requests were made after various amendments to the arrangements leading to further rulings from the Tax Office.

3. The commercial objectives to the extension to the Agreement outlined in the background below are:

(a) to continue the dividend policy with respect to the payment of dividends by A vis-à-vis its funding requirements; and

(b) the continuation of the protocols for the funding of the capex requirements of entities in the ABCD venture between a non-resident company D and Australian company C. A is part of the ABCD venture and is jointly owned by B (an Australian company wholly owned by D) and C.

4. The parties have amended, subject to receiving a suitable ruling, the agreement to continue the terms of that arrangement. This involves the continuation of the agreement, and the continuation of Funding Dividends and Funding Loans. What these arrangements seek to achieve, as with the existing arrangements, are summarised as follows:

(a) capital expenditure requirements of ABCD entities can in certain circumstances trigger requirements of A to pay additional dividends to its shareholders. Further the parties may mutually agree that A will pay further dividends outside the requirements of the agreement;

(b) in respect of the capital expenditure requirements of A itself, an amount equivalent to these capex requirements (including working capital) or the dividend pursuant to the agreement or further dividends, may be lent to A (via the B&C Partnership with equity subscriptions from B and C into the partnership); and

(c) in relation to capital expenditure requirements of other ABCD entities the funding requirement could trigger a dividend (either under the agreement or as a result of further dividends). The capex requirements of these ABCD entities could be satisfied by an interest bearing loan from the ABCD members, the B&C Partnership or A. Alternatively, the parties could fund the capex requirements of these ABCD entities via an equity injection into the ABCD entity by its shareholders.

5. Relevant background information is provided below regarding:

(a) The operation of the Agreement and Funding Dividends;

(b) The anticipated capital expenditure on expansion projects;

(c) The Agreement arrangements; and

(d) Background on C and D's Australian groups.

6. Copies of all relevant documents were included in the ruling request.

7. Some changes to the agreement were made several years ago. One condition in particular in the agreement restricts the payment of dividends pursuant to the agreement. The shareholders have agreed in principle to relax this requirement.

8. The parties further amended the Agreement and loan arrangement.

9. The income tax issues on which the parties seek a ruling are the same issues as addressed in the previous rulings noted above. That is the confirmation that loans provided to ABCD entities (including A) under the terms of the Agreements and Funding Loans are debt for Division 974 of the ITAA 1997 purposes.

Background Information

Commercial Objectives

10. Since the original ruling request several years ago ABCD's product market has experienced price decreases and overcapacity, in part due to the global financial crisis.

11. Within ABCD, several upgrades to their facilities have been made in the past few years.

12. Whilst there are no committed major projects, potential capex spend for ABCD exists in relation to:

(a) potential expansions and upgrades,

(b) large sustaining capex in the future.

13. In addition the ABCD enterprises will have ongoing capex requirements to sustain existing facilities.

14. The schedule and ordering of expansion and spend will depend on commercial issues such as cost and pricing of ABCD's product.

Dividends of A

15. A is the head company of a consolidated group.

16. Fully franked dividends are regarded as an important criterion for shareholders investing in C, and releasing franking credits of A via the proposed arrangement to which this ruling request relates will permit C to maintain franking of its dividends in the medium to long term.

17. C's board determines dividends paid to shareholders based on performance and expected business conditions. Its intention is, to the extent practicable, to fully distribute to shareholders all fully franked dividends received by C from ABCD. Dividend payments will be subject to current and expected business conditions.

18. To continue the formalisation of A's dividend practice and to accommodate ABCD's potential and proposed funding requirements (including A's own funding requirements), it is proposed that A, B, C, D and the B&C Partnership continue the agreement as amended and B and C enter into the amended B&C Partnership to facilitate funding of ABCD projects.

19. In the parties amended, subject to the receipt of a favourable ruling, the Agreement, the B&C Partnership Agreement and the loan arrangement. The amendment agreement for the Agreement provides that:

(a) some of the requirements to provide Agreement Loans be amended; and

(b) the Agreement to be a continuing agreement, with one year's notice from either party.

20. The B&C Partnership agreement was amended to tie in the notice of termination provisions to the termination of the Agreement.

21. Dividends are paid at the beginning of a quarter or month in respect of interim net income for all previous quarters since 1 January 200X less any amount of such income that has already been paid out as dividends.

22. The payment of dividends is, in summary, subject to:

(a) compliance with section 254T of the Corporations Act 2001 (Corporations Act);

(b) not causing A to be unable to pay its debts; and

(c) for dividends in excess of the minimum dividends, the ability to fully frank the dividend and the next scheduled minimum dividend.

Funding of ABCD Capital Requirements

23. As discussed at paragraph 12, ABCD is examining a number of other capex requirements within the ABCD joint venture. Also the ABCD enterprise entities will have ongoing capex requirements to sustain existing infrastructure and facilities.

24. Some of the future capital expansion will be funded directly and independently (that is, not via the B&C Partnership) by C and D or by ABCD entities where quarterly dividends are not sufficient to fund the calls.

B&C Partnership

25. Key terms of the Agreement Loans are that each loan will be:

(a) unsecured,

(b) used to fund the working capital requirements of the borrower (including A), subject to an aggregate limit,

(c) repayable by X,

(d) subject to commercial arm's length interest rates.

26. The amounts to be provided to A to fund A's capex including ongoing capex to sustain existing facilities, are anticipated to be provided by Agreement Loans as contemplated in the Loan Arrangement. The B&C Partnership is an Australian general law partnership with both B and C subscribing for equity in the partnership in their existing respective interests in A.

27. The B&C Partnership may then loan funds to A as a drawdown on the loan arrangement on commercial arm's length terms.

28. D is seeking to address an issue that arises as it consolidates in its accounts a 100% interest in A before making adjustments to eliminate minorities. Under current accounting, D would, on A borrowing funds, consolidate in the preparation of its accounts 100% of the debt shown on A's balance sheet, notwithstanding it only has a X% interest in A. This adversely impacts on the perceived gearing level of D.

29. The accounting for the B&C Partnership enables D to consolidate 100% of the A debt but also 100% of the asset being the loan from the B&C Partnership. This addresses the disproportionate accounting gearing impact.

Funding Dividends and Funding Loans

30. In addition, the shareholders in A (who are also the partners in the B&C Partnership) wish to have the ability to be able to mutually agree to pay further dividends from A and to make additional loans as Funding Loans to A of up to a cumulative limit. Naturally the parties will not agree to pay Funding Dividends where this would cause a breach of section 254T of the Corporations Act or cause A to be unable to pay its debts. The total value of loans made whether in accordance with the Agreement or not, is not to exceed the limit. These Funding Dividends and Funding Loans will be implemented by the movement of funds between bank accounts of the relevant entities.

31. The key differences between Funding loans and Agreement Loans are that the former will not be subject to the requirements of the agreement and may not necessarily be linked to available cash and they have a different repayment term.

32. In summary, the Funding Dividends and resulting Funding Loans may be made where:

(a) C and D (through its wholly owned subsidiary, B) agree to facilitate the payment of a dividend by A; and

(b) The resulting Agreement Loans and Funding Loans do not exceed the aggregate limit.

Shareholder background

D Group

33. The D group holds its interest in A interest through its wholly-owned Australian subsidiary B.

C Company

34. C holds a less than 50% interest in A

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Income Tax Assessment Act 1997 Division 974.

Income Tax Assessment Act 1997 subsection 974-10(3).

Income Tax Assessment Act 1997 section 974-15.

Income Tax Assessment Act 1997 subsection 974-15(2).

Income Tax Assessment Act 1997 section 974-20.

Income Tax Assessment Act 1997 subsection 974-20(1).

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

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

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

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

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

Income Tax Assessment Act 1997 section 974-80.

Income Tax Assessment Act 1997 subsection 974-80(1).

Income Tax Assessment Act 1997 subsection 974-80(2).

Income Tax Assessment Act 1997 section 974-130.

Income Tax Assessment Act 1997 section 974-135.

Income Tax Assessment Act 1997 section 974-155.

Income Tax Assessment Act 1997 section 974-160.

Corporations Act 2001 section 254T.

Explanation: (This does not form part of the notice of private ruling)

Question 1

Detailed reasoning

Will an Agreement Loan from the B&C Partnership which will be made on a commercial arm's length basis and must be repaid, be treated as debt pursuant to section 974-15 of the ITAA 1997?

1. Division 974 of the ITAA 1997 sets out rules to define what should be categorised as 'equity' in a company and what is 'debt'. This distinction is important as it determines how to treat an amount paid by a company in respect of a financing interest that it has issued. If the amount paid is an equity interest it will be treated as a frankable dividend, however if it is a debt interest it will be treated as interest on a debt, which may qualify as a deduction under section 8-1 of the ITAA 1997.

2. In order to be a debt interest, a scheme must satisfy the debt test in section 974-20 of the
ITAA 1997. For the purposes of Division 974 of the ITAA 1997, the scheme in the case at hand can be described as consisting of each Agreement Loan made pursuant to the Agreement and in accordance with the terms of the loan arrangement. The basic principle in the Agreement is that A will pay dividends to the extent required to fund capital funding requirements of the ABCD venture, including A's own capital funding requirements. Generally, funding will be by way of (Agreement) loans from the B&C Partnership to A, or other ABCD entities. However, funding can also be by equity contributions or from external borrowings if certain limitations apply including the monetary limit on the B&C Partnership Loans.

3. The conditions for a scheme to satisfy the debt test are set out in subsection 974-20(1) of the ITAA 1997, as follows:

A *scheme satisfies the debt test in this subsection in relation to an entity if:

(a) the scheme is a *financing arrangement for the entity; and

(b) the entity, or a *connected entity of the entity, receives, or will receive, a *financial benefit or benefits under the scheme; and

(c) the entity has, or the entity and a connected entity of the entity each has, an *effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when:

(i) the financial benefit referred to in paragraph (b) is received if there is only one; or

ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and

(d) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and

(e) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil.

The Debt test applied to the proposed arrangement

4. Paragraph 974-20(1)(a) of the ITAA 1997 contains the first condition, that is the scheme must be a 'financing arrangement' for the entity. A 'financing arrangement' is widely defined in
section 974-130 of the ITAA 1997 and includes 'a scheme entered into to raise finance for the entity'. The Agreement Loans to be loaned by the B&C Partnership under the loan arrangement would fall within this definition as their stated purpose is to provide finance for the capital expenditure requirements of ABCD entities including A. Therefore the first test in section 974-20 of the ITAA 1997 is satisfied.

5. The next test in paragraph (b) of subsection 974-20(1) of the ITAA 1997 requires the entity (or a connected entity) to receive a 'financial benefit' (greater than nil) under the scheme. A 'financial benefit' is also widely defined in section 974-160 of the ITAA 1997 to include anything of economic value, including property and services. Paragraph 2.164 of the Explanatory Memorandum to the New Business tax System (Debt and Equity) Bill 2001 states that in a simple example of a debt interest where money is loaned with an obligation to repay with interest, the financial benefit will be the sum of money being loaned. The receipt of the money and the obligation to repay it are to be looked at separately. Hence for the proposed arrangement, the financial benefit will be the funds drawn down by A or other ABCD entity for each Agreement Loan under the loan arrangement. Therefore A (or another borrowing ABCD entity) will receive a financial benefit for each loan, so this test is also satisfied.

6. The third test, in paragraph 974-20(1)(c) of the ITAA 1997, requires the entity to have (or the entity and a connected entity must both have) an 'effectively non-contingent obligation' under the scheme to provide financial benefit(s) to one or more entities after the time that entity received the financial benefit. The meaning of an 'effectively non-contingent obligation' is found in
section 974-135 of the ITAA 1997. Broadly, the term refers to an obligation that is not contingent on any event, condition or situation other than the ability or willingness of the relevant entity or connected entity to meet the obligation.

7. In the arrangement being considered, when A receives an Agreement Loan for capital expenditure under the Agreement, it will have to repay the loan no later than the repayment term plus interest calculated at commercial arm's length rates. The interest rate is calculated at commercial arm's length rates. Where another ABCD entity is the borrower an arm's length interest rate needs to be determined by the lender based on the borrower's credit status.

8. The above requirement for loan repayment with interest by A or another ABCD entity is non-contingent. That is, there are no contingencies in the terms of the Agreement or the Loan Arrangement under which ABCD entities including A could avoid having to repay the Agreement Loans with interest. The Agreement does allow for a temporary suspension of X business days of loan obligations in certain circumstances but this suspension is only for X business days and it does not change the ultimate obligation to repay all amounts by the repayment term.

9. The reference to the 'unwinding' of the funding mechanisms referred to in the Agreement in the event of a Tax Event does not mean that the loans would not have to be repaid. The loans must still be repaid by A (or whichever other ABCD entity had borrowed funds), even if the proposed funding arrangement was finalised early due to an unfavourable tax ruling.

10. From the above, it is concluded that the borrowing entities including A will have an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities. That is, the test in paragraph 974-20(1)(d) of the ITAA 1997 is satisfied.

11. The condition in paragraph 947-20(1)(d) of the ITAA 1997 requires it to be substantially more likely than not that the value of the financial benefit to be provided (under paragraph (c) above) under the scheme will be at least equal to the value of the benefit to be received (under paragraph (b)).

12. As the amounts to be loaned to ABCD entities including A will be repayable in addition to commercial rates of interest, clearly the amount of the non-contingent obligation owed by the borrowing ABCD entity will exceed the value of the amount loaned to it. Hence this test will also be satisfied.

13. The final condition, in paragraph 974-20(1)(e) of the ITAA 1997, simply requires the value of the benefits received and provided to be more than nil. This was stated to be the case in the ruling request,

Related schemes

14. In determining the debt/equity characterisation it is also necessary to consider if there are related schemes in this case. For example, a series of Agreement Loans made by the B&C Partnership to A could be regarded as being a series of related schemes. If there is more than one scheme then the debt/equity test must be considered taking into account all the related schemes, and not just single transactions such as each loan to A (subsection 974-10(3) of the ITAA 1997).

15. In this case the Agreement Loans from the B&C Partnership to ABCD entities including A are preceded by calls and Agreement Dividends paid by A to its shareholders B and C. The Agreement Dividends are then loaned to A or other ABCD entities through the B&C Partnership. These preceding steps might be considered to be 'related schemes', which is defined broadly in section 974-155 of the ITAA 1997 as schemes which are 'related to one another in any way'.

16. However, even if the dividends paid by A are treated as related (integrated) with the Agreement Loans to ABCD entities under subsection 974-15(2) of the ITAA 1997, the combined operation of these 'schemes' is considered to still satisfy the debt test. The overall result continues to be that the ABCD entity has an effectively non-contingent obligation under the related schemes to provide a financial benefit which will exceed the value (of the Agreement Loans) received. The Agreement Dividends will not be reinvested as equity in the ABCD entity, but a related amount will be loaned and repaid on commercial terms.

17. Therefore whether or not there are related schemes in this case, the same conclusion applies. In either case the debt test will be passed and hence Agreement Loans made pursuant to the Agreement will each give rise to debt interests in A or in another borrowing ABCD entity.

Connected entity

18. Section 974-80 of the ITAA 1997 can apply in certain circumstances to re-characterise debt interests as equity interests, if equity interests arise from arrangements which fund returns through connected entities. From subsection (1), section 974-80 applies if:

(a) an interest carries a right to a variable or fixed return from a company; and

(b) the interest is held by a *connected entity of the company; and

(c) apart from this section, the interest would not be an *equity interest in the company; and

(ca) the *scheme that gives rise to the interest is a *financing arrangement for the company; and

(d) there is a scheme, or a series of schemes, designed to operate so that the return to the connected entity is to be used to fund (directly or indirectly) a return to another person (the ultimate recipient).

19. Subsection 974-80(2) of the ITAA 1997 operates to treat the interest as an equity interest in the company if:

(a) the amount of the return to the ultimate recipient is in substance or effect *contingent on the economic performance (whether past, current or future) of:

the company; or

a part of the company's activities; or

(iii  a *connected entity of the company or a part of the activities of a connected entity of the company; or

(b) either the right itself, or the amount of the return to the ultimate recipient, is at the discretion of:

the company; or

(ii)  a connected entity of the company; or

(c) the interest in respect of which the return to the ultimate recipient is made or another interest that arises from the scheme, or any of the schemes, referred to in paragraph (1)(d):

gives the ultimate recipient (or a connected entity of the ultimate recipient) a right to be issued with an *equity interest in the company or a connected entity of the company; or

 is an *interest that will, or may, convert into an equity interest in the company or a connected entity of the company;

and if the interest does not form part of a larger interest that is characterised as a *debt interest in the entity in which it is held, or a *connected entity, under Subdivision 974-B. The return may be a return of an amount invested in the interest.

20. The Supplementary Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 states that section 974-80 of the ITAA 1997 is intended to apply:

only in those cases where the scheme or schemes are deliberately designed so that the return to the connected entity is in turn used to fund directly or indirectly a return to the ultimate recipient. This means, generally speaking, that section 974-80 would not apply unless there is a plan constituted by documented rights and obligations that provide for the direct or indirect funding of a return to the ultimate recipient. A lack of documentation would not preclude the application of the provision if the design was clear from the surrounding facts and circumstances. However, mere association between the parties would not be a sufficient indicator of the relevant design. (paragraphs 1.28 and 1.29)

21. In the case at hand, section 974-80 of the ITAA 1997 could only apply if the returns from the Agreement Loans (that is, the interest to be paid by A or another ABCD borrowing entity) were designed to fund an equity like return to connected entities of A, such as B and C, which in turn is to be used to fund a return to the ultimate recipient. The ultimate recipient presumably could be the shareholder of B, (that is, D) or the shareholders of C.

22. Nothing in the proposed arrangement indicates that the interest to be paid by A in respect of the Agreement Loans will be used to fund an equity return to D or C's shareholders. Dividends will continue to flow to B and to C under the proposed arrangement. In the case of C, the interest it receives (via the EP) will be used to fund its interest debts (relating to its borrowings to loan funds to ABCD entities (including A) via the B&C Partnership, in response to calls.

As there is nothing in the Agreement, or in any of the other information available to indicate any equity funding through connected entities, it is considered that section 974-80 of the ITAA 1997 would not apply in this case.

Conclusion

23. As the tests in section 974-20 of the ITAA 1997 are satisfied, the Agreement Loans made pursuant to the Agreement and in accordance with the terms of the Loan Arrangements will be treated as debt pursuant to section 974-15 of the ITAA 1997 and each give rise to a debt interest.

Question 2

Detailed reasoning

Will a Funding Loan made after 31 December 2010 from the B&C Partnership, which will be made on a commercial arm's length basis and must be repaid, be treated as debt pursuant to section 974-15 of the ITAA 1997?

1. The next question concerns whether a Funding Loan made after 31 December 2010 from the B&C Partnership to A, which will be made on a commercial arm's length basis and must be repaid, will be treated as debt pursuant to section 974-15 of the ITAA 1997.

2. The shareholder's of A, being B and C, wish to provide for A's post 1 January 200X capex by way of loans, which will facilitate dividends of the same amount. However they do not wish to be only able to do this when the Agreement requires Agreement Loans. Instead, they wish to also be able to do this when they agree it is appropriate, that is, when they mutually agree to pay a dividend (a 'Funding Dividend'). These dividends will be loaned back to A via the B&C Partnership as 'Funding Loans', not Agreement Loans under the Agreement.

3. Funding Loans will be similar to Agreement Loans in all material aspects when considering whether the funds should be categorised as debt or equity.

4. Unlike Agreement Loans, all Funding Loans will be made from the B&C Partnership to the A Group only, and not to any other ABCD entities.

5. Unlike Agreement Loans subject to the Agreement, Funding Dividends and Funding Loans will not be subject to the requirements of the Agreement and may not necessarily be linked to calls or available cash. Funding Loans made in response to a Funding Dividend will be linked to replacing the working capital employed by A which was paid out to as that dividend.

6. Funding Loans made after 31 December 2010 have a Repayment Term being less than P years of entering in the loan or in any case by 31 December 20XX and include commercial interest rates.

7. These differences are not considered material when concerning the categorisation of the loan as debt or equity. There are still no contingencies in the terms of Funding Loans made after 31 December 2010 where A would avoid having to repay the Funding Loans with interest.

8. Therefore, in principle the same conclusion applies in respect of the categorisation of Funding Loans as debt pursuant to section 974-15 as considered for Agreement Loans above.

Conclusion

9. The differences between Funding Loans and Agreement Loans are not significant in respect of their categorisation as debt or equity in Division 974 ITAA 1997. Accordingly, Funding Loans will also be treated as debt pursuant to section 974-15 of the ITAA 1997 as the tests in section 974-20 are satisfied and will each give rise to a debt interest.