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Ruling

Subject: Classification of convertible notes as debt or equity interests; Deductibility of interest payments on convertible notes; Application of s 775-25 of the ITAA 1997 to forex realisation gains

Question 1

Do the convertible notes issued by the Company qualify as a debt or equity interest for the purposes of subsections 974-20(1) and 974-75 (1) respectively of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

The convertible notes issued by the Company are considered to be an equity interest for the purposes of subsection 974-75(1) of the ITAA 1997.

Question 2

Does section 26-26 of the ITAA 1997 preclude the Company from claiming a deduction for interest paid on the convertible notes.

Answer

Yes. Section 26-26 of the ITAA 1997 precludes the Company from claiming a deduction for interest paid on the convertible notes.

Question 3

If the convertible notes are treated as an 'equity interest' for the purposes of subsection 974-75(1) of the ITAA 1997, are realised foreign exchange gains and losses made by the Company in gaining or producing non assessable non exempt (NANE) income excluded from being assessable or deductible respectively under section 775-25 and section 775-35 of the ITAA 1997?

Answer

Yes. When Forex Realisation Event 4 (FRE 4) applies, forex realisation gains made by the Company are treated as NANE income under section 775-25 of the ITAA 1997 to the extent that if they had been forex losses, they would have been made in gaining or producing NANE income of the Company.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Background

The Company, an Australian resident, was incorporated with the goal of raising funds to acquire a suite of businesses in Country A.

The Company entered into a Convertible Note Subscription Agreement ('Agreement') with Subscribers (Noteholders) for the issue of Notes bearing a face value in the Country A currency.

Under the terms of the Agreement, the Notes will convert upon the occurrence of certain events such as on the event of default, redemption by a Noteholder, redemption by the Company, conversion by a Noteholder including an automatic conversion event.

The Company was required to pay interest on the value of the Notes.

The Company utilised cash from the issue of the convertible notes to fund the acquisition of shares in a number of Country A entities such that the Company owned 100% of the issued capital of those entities.

Subsequently, on the occurrence of the automatic conversion event, the convertible notes on issue converted into shares under the terms of the Agreement.

Since its incorporation the Company has not actively traded, it has only operated as a head investment entity.

In the future, the Company expects to receive dividends from its Country A subsidiaries. The receipt of dividends, apart from foreign exchange movements, is the only expected source of income for the Company.

The Company realised gains and losses from foreign exchange movements as a result of the difference in the currency exchange rate (rate) that applied at the time the Company raised Country A currency denominated funds through the issue of the convertible notes, and the applicable rate at the time all of the convertible notes converted into shares in the Company.

It is advised that, for income tax purposes, the Company realised forex gains when the convertible notes converted to shares.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 Subsection 974-20(1)

Income Tax Assessment Act 1997 Subsection 974-30(1)

Income Tax Assessment Act 1997 Subsection 974-70(1)

Income Tax Assessment Act 1997 Subsection 974-75(1)

Income Tax Assessment Act 1997 Subsection 974-75(2)

Income Tax Assessment Act 1997 Subsection 974-130(1)

Income Tax Assessment Act 1997 Subsection 974-135(4)

Income Tax Assessment Act 1997 Section 974-115

Income Tax Assessment Act 1997 Section 974-120

Income Tax Assessment Act 1997 Section 26-26

Income Tax Assessment Act 1997 Section775-25

Income Tax Assessment Act 1997 Section 775-35

Income Tax Assessment Act 1997 Section 775-55

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies, the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

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 a part.

If you want us to rule on whether Part IVA applies we will first 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 at www.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

In respect of a scheme that was entered into on or after 1 July 2001, Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) provides rules that govern the classification of debt and equity interests for instruments issued under the scheme.

Debt test

The debt test is contained in subsection 974-20(1) of Subdivision 974-B of the ITAA 1997.

A scheme satisfies the debt test in subsection 974-20(1) of the ITAA 1997 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:

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

b. 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 than 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.

Scheme is a 'financing arrangement'

The Company entered into a Convertible Note Subscription Agreement to fund the acquisition of certain Country A entities. In this regard, the scheme which the Company has entered into constitutes a 'financing arrangement' and will therefore satisfy paragraph 974-20(1)(a) of the ITAA 1997.

Issuing entity receives 'financial benefit'

Subsection 974-160(1) of the ITAA 1997 provides that financial benefit:

(a) means anything of economic value; and

(b) includes property and services; and

(c) includes anything that regulations made for the purposes of subsection 974-160(3) provide is a financial benefit;'

even if the transaction that confers the benefit on an entity also imposes an obligation on the entity.'

The Company will receive the 'issue price' from the issue of each Note that has an economic value in relation to the Country A currency. The total amount received by the Company from the subscribers (Noteholders) will therefore constitute a 'financial benefit' for the purposes of paragraph 974-20(1)(b) of the ITAA 1997).

Issuer has an effectively non-contingent obligation to provide a financial benefit

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

Subsection 974-135(1) of the ITAA 1997:

'There is an effectively non-contingent obligation to take an action under a *scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation (see subsections (3), (4) and (6)) to take that action)'.

Subsection 974-135(3) of the ITAA 1997:

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

Subsection 974-135(4) of the ITAA 1997:

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

Subsection 974-135(6):

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

Paragraph 974-30(1)(b) of the ITAA 1997 provides that an amount that is to be applied in respect of the issue of an equity interest in the issuer does not constitute the provision of a 'financial benefit'.

Presently, the terms of issue of the Notes provide for:

· Payment of interest by the Company to the Noteholders;

· The redemption of the Notes for their face value;

· The conversion of the Notes into ordinary shares by Noteholders; and

· Automatic conversion of the Notes into ordinary shares.

The following financial benefits are therefore payable under the Notes:

· Interest payable on the Notes for their face value; and

· Amount payable on redemption of the Notes for their face value.

For these financial benefits to be taken into account it needs to be determined whether they are financial benefits that the entity is under an effectively non-contingent obligation to provide (paragraph 974-20(1)(c) of the ITAA 1997).

The Company must pay interest accrued on each of the Notes. Therefore, the amount of interest and the right to interest under the Notes are not contingent on the discretion of the Company.

The Notes will be redeemed at face value unless they have already been converted into shares. Any redemption of the Notes will result in the provision of a financial benefit by the Company to the Noteholders. The provision of the financial benefit is however, contingent on the non-conversion of the Notes prior to the exercise of the Noteholder's right to redeem the Notes on the Maturity Date.

As provided in subsection 974-135(4) of the ITAA 1997, the existence of the right of conversion of the Noteholder as contained in Clause 9 of the Agreement will not of itself make the Company's obligation to repay the investment, not non-contingent.

However, in the circumstances of this case a contingency exists in addition to the Noteholder's right to convert the Notes which is about an automatic conversion event.

On the occurrence of the automatic conversion event, the Company can in substance or effect avoid any obligation to redeem the Notes at maturity and instead provide shares. The provision of shares by the Company under an automatic conversion event will not constitute the provision of a financial benefit under subsection 974-30(1) of the ITAA 1997.

Subsection 974-135(6) provides that any artificial or contrived contingencies may be disregarded when determining whether an issuer has in substance or effect a non-contingent obligation to provide a financial benefit. In the circumstances of this case there is nothing to suggest that the contingency brought about by the automatic conversion event is artificial or contrived.

Accordingly, the Company's only effectively non-contingent obligation to provide a financial benefit under the Arrangement is the payment of the interest.

Having regard to the pricing, terms and conditions of the Convertible Notes it cannot be said that the Company has in substance or effect a non-contingent obligation to provide financial benefits in respect of the face value of the Notes under the terms of the Agreement.

Consequently, it is concluded that the Company does not have an effectively non-contingent obligation to provide financial benefits to the Noteholder under paragraph 974-20(1)(c) of the ITAA 1997.

As a result of the third element of the debt test not being satisfied there is no need to consider further elements of the debt test.

Equity test

Subsection 974-70(1) of the ITAA 1997 provides that 'a scheme gives rise to an equity interest...' when the scheme '…satisfies the equity test…' and '…the interest is not characterised….as a debt interest in the company...'

Subsection 974-75(1) of Subdivision 974-C of the ITAA 1997 states that "a scheme satisfies the equity test in this subsection…" if an interest falls within one of the items stated in the subsection.

Relevantly, item 4 of subsection 974-75(1) of the ITAA 1997 refers to:

4. An interest issued by the company that:

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

b) is an interest that will, or may, convert into an equity interest in the company or a connected entity of the company.

The Notes issued by the Company were to be converted into shares in the Company upon the occurrence of certain events, including an automatic conversion event.

As the convertible notes may convert into an equity interest in the company, they satisfy the basic test for an equity interest pursuant to item 4 of the table in subsection 974-75(1) of the ITAA 1997.

Subsection 974-75(2) of the ITAA 1997 then provides:

A scheme that would otherwise give rise to an equity interest in a company because of an item in the table in subsection (1) (other than item 1) does not give rise to an equity interest in the company unless the scheme is a 'financing arrangement' for the company.

Paragraph 974-130(1)(a) of the ITAA 1997 further provides:

A scheme is a financing arrangement for an entity if it is entered into or undertaken to raise finance for the entity…….

The arrangement between the Company as the issuer and the Noteholder in relation to the convertible notes falls within the ambit of a 'scheme' which is defined very broadly in subsection 995-1(1) to include 'any arrangement'.

The Company is seeking to raise funds through the issue of convertible notes. The funds raised will be used to acquire shares in a number of Country A entities. Therefore, the scheme is a financing arrangement under paragraph 974-130(1)(a) of the ITAA 1997.

In summary, it is considered that the convertible notes satisfy the equity test in Division 974 of the ITAA 1997.

Tiebreaker test

Where both the debt and equity tests are satisfied, the tiebreaker test provides that the interest is a debt interest. In the circumstances of this case, as the debt test is not satisfied, there is no need to consider the tiebreaker test.

Conclusion

The convertible notes issued by the Company are considered to be equity interests in the Company as they:

· satisfy the equity test in subsection 974-75(1) of the ITAA 1997;

· do not satisfy the debt test in subsection 974-20 (1) of the ITAA 1997; and

· they are not part of a larger interest that is classified as a debt interest.

Question 2

In the arrangement under consideration, the convertible notes issued by the Company that triggered the existence of an equity interest in the Company ('shares'), are themselves an equity interest for the purposes of item 4 in subsection 974-75 of the ITAA 1997. In this case, the convertible notes will be classified as a 'non-share equity interest' under subsection 995-1(1) of the ITAA 1997.

As a general rule, equity interests are treated alike for the purposes of determining the taxation treatment of returns whether or not they are shares in a legal form.

One of the main consequences of the debt and equity classification is the issuer's ineligibility to claim a deduction for returns and distributions on non-share equity interests where such returns or distributions would otherwise be deductible because it is deductible interest.

As explained in ATO ID 2002/1113, section 974-115 of the ITAA 1997 provides that a non-share distribution arises where you hold a non-share equity interest in a company and the company, as a result of you being a non-share equity interest holder, distributes money to you, distributes other property to you or credits an amount to you.

In turn, section 974-120 of the ITAA 1997 provides that all non-share distributions are non-share dividends to the extent to which those distributions do not represent a return of non-share capital or share capital.

In the present case, the payments of interest by the Company on the non-share equity interest would give rise to a non-share distribution under section 974-115 of the ITAA 1997 because the interest would be paid as a result of the note holder being a holder of a non-share equity interest.

Those non-share distributions being the regular interest payments on the convertible note would not represent distributions of non-share capital or share capital. Accordingly, the distributions paid on the non-share equity interest [the convertible note] would be non-share dividends pursuant to the operation of sections 974-115 and 974-120 of the ITAA 1997.

Section 26-26 denies a company a deduction for a non-share distribution and a return that has accrued on a non-share equity interest.

Section 26-26 of the ITAA 1997 applies to transactions that take place after 1 July 2001, regardless of whether the equity interest was issued before, on or after that date.

Section 26-26(1)(a) makes a distribution made or credited by a company to the holder of a non-share equity interest non-deductible.

Section 26-26(1)(b) ensures that any liability incurred by a company for a return that has accrued but has not yet been distributed or credited to the holder of a non-share equity interest is also non-deductible.

Consequently, in the circumstances of the Company, interest payments that are considered to be non-share dividends made to the Noteholders would not be deductible to the Company by virtue of the operation of section 26-26(1)(a) of the ITAA 1997. This is consistent with the ATO view contained in ATO ID 2002/1115.

Additionally, returns accrued but not paid to the Noteholders in respect of their interests in the convertible notes are also not deductible pursuant to section 26-26(1)(b) of the ITAA 1997

Question 3

Under Division 775 of the ITAA 1997, forex realisation gains are included in assessable income under section 775-15 of the ITAA 1997, while forex realisation losses are deductible under section 775-30 of the ITAA 1997.

Subsection 775-30(1) states that:

You can deduct from your assessable income for an income year a forex realisation loss that you make as a result of a forex realisation event that happens during that year.

However, one exception to this general principle is the treatment of forex realisation gains and losses relating to gaining or producing non-assessable non-exempt (NANE) income.

Section 775-25 of the ITAA 1997 provides that:

A forex realisation gain you make is non-assessable non-exempt income to the extent that, if it had been a forex realisation loss, it would have been made in gaining or producing non-assessable non-exempt income.

Section 775-35 of the ITAA 1997 states:

(1) A forex realisation loss you make as a result of forex realisation event 1, 2 or 5 is disregarded to the extent that it is made in gaining or producing exempt income or non-assessable non-exempt income.

(2) A forex realisation loss you make as a result of forex realisation event 3, 4 or 6 is disregarded to the extent that:

(a) it is made in gaining or producing exempt income or non-assessable non-exempt income; and

(b) the obligation, or part of the obligation, does not give rise to a deduction.

The words 'to the extent that' indicate that an apportionment of a forex realisation loss in circumstances such as those in the present case is allowable under the legislation.

Discharge of obligation to pay foreign currency

Forex Realisation Event 4 (FRE4) in section 775-55(1) of the ITAA 1997 happens if a taxpayer ceases to have an obligation (or part of an obligation) to pay foreign currency for any reason, including the fact that the taxpayer has paid it.

The cessation of an obligation (or part of an obligation) can trigger the happening of FRE 4 where the obligation is incurred in return for receiving an amount of Australian or foreign currency {subparagraph 775-55(1)(b)(ix)}.

The term 'foreign currency' is defined in subsection 995-1(1) of the ITAA 1997 to mean a currency other than Australian currency.

The extended meaning of the term 'obligation to pay foreign currency' in section 775-140(1) of the ITAA 1997 includes an obligation to pay an amount that is calculated by reference to a "currency exchange rate effect" even if that amount is not an amount of foreign currency. So long as there is an obligation to pay an amount which is calculated by reference to a currency exchange rate effect, it will qualify as an obligation to pay foreign currency.

Furthermore, the amount paid to discharge the obligation to pay foreign currency includes a non-cash benefit pursuant to subsection 775-55(6) of the ITAA 1997. Section 995-1 of the ITAA 1997 defines 'non-cash benefits' as property or services in any form except money. In this regard, the Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Act (No. 1) 2003 provides at paragraph 2.138 that, for the calculation of the total payment, the market value of the benefit (worked out at the time of the event) is used.

FRE4 captures forex movements between the period when the obligation to pay foreign currency arises and when it is actually discharged by the taxpayer.

Under subsection 775-55(3) of the ITAA 1997 a gain arises under FRE 4 if the amount paid to discharge the obligation is less than the amount received for assuming the obligation or the part of the obligation to pay foreign currency.

The amount of the forex realisation gain is so much of the shortfall as is attributable to a "currency exchange rate effect".

Under subsection 775-55(5) of the ITAA 1997 a loss arises under FRE 4 if the amount paid to discharge the obligation is more than the amount received for assuming the obligation or the part of the obligation to pay foreign currency.

The amount of the forex realisation loss is so much of the excess as is attributable to a currency exchange rate effect.

The Company assumed an obligation to pay Country A currency by raising funds denominated in the Country A currency through the issue of convertible notes and subsequently discharged that obligation by issuing to the Noteholders, shares in the Company.

It is considered that the appropriate forex realisation event that applies in the Company's circumstances is FRE4. This is so as the discharge by the Company of its obligation to the Noteholders is not characterised by:

· the disposal of foreign currency or a right, or a part of a right, to receive foreign currency (FRE1 in section 775-40 of the ITAA 1997); or

· the cessation of a right (or a part of a right) to receive foreign currency (FRE2 in section 775-45 of the ITAA 1997); or

· the cessation of an obligation (or a part of an obligation) to receive foreign currency (FRE 3 in section 775-50 of the ITAA 1997); or

· cessation of a right to pay foreign currency in return for assuming an obligation to pay foreign or Australian currency (FRE5 in section 775-60 of the ITAA 1997); or

· discharge of obligation to pay the principal amount of a notional loan under a facility agreement (FRE6 in section 775-215 of the ITAA 1997).

FRE4 occurred when all of the convertible notes issued by the Company, that have since been categorised as equity interests, converted to shares.

It is considered that the provision of shares in the Company in the present circumstances, equates to the provision of non-cash benefits for the purposes of subsection 775-55(6) of the ITAA 1997.

A shortfall arises where the total amount paid by the Company, being the market value of the shares on their date of issue, to discharge its obligation is lesser than the amount received in the Country A currency from the issue of the convertible notes

To the extent the shortfall is directly attributable to a currency exchange rate effect, it is considered that the Company has realised forex gains on the discharge of its obligation, under subsection 775-55(3) of the ITAA 1997.

The currency exchange rate effect is caused by the fluctuation in the value of the Australian dollar in relation to the Country A currency between the time of the issue of the convertible notes and the time when the convertible notes converted into shares.

The funds raised by the Company from the issue of the convertible notes were employed to acquire shares in its Country A subsidiaries. As a direct result of the Company's shareholding, it will derive non assessable non exempt (NANE) income in the nature of 23AJ dividends from its Country A subsidiaries.

The Company has, for income tax purposes, realised forex gains under FRE4 in the relevant income year consequent to the discharge of the Company's obligation to repay Country A currency raised under the convertible notes.

The forex gains are considered to be NANE income under section 775-25 of the ITAA 1997 to the extent that the funds raised by the Company from the issue of the convertible notes were used to acquire shares in its Country A subsidiaries. This is due to the fact that if the forex gains had been forex losses, they would have been made in gaining or producing NANE income of the Company.

This conclusion is in accordance with ATO Interpretative Decisions ATO ID 2004/571 and 2004/572.