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Ruling

Subject: Redeemable Preference Shares

Question

Will the distributions (franked dividends) from the Company to the redeemable preference shareholders be treated as payments of dividends capable of being franked under section 202-40 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Income year ended 30 June 2012

Income year ended 30 June 2013

Income year ended 30 June 2014

The scheme commences on:

1 July 2011

Relevant facts

Background

The Company currently has $1.00 issued ordinary shares (fully paid) divided equally between its current shareholders.

The Scheme of Arrangement - RPS

The Company intends to issue 100 fully paid $1.00 redeemable preference shares.

The RPS will be issued in proportion to the ordinary shareholding.

It is intended to pay the RPS shareholders a fully franked dividend from the company's franking account.

All the shareholders are Australian residents for income tax purposes.

The Redeemable Preference Shares

The proposed RPS issue has the full consent of all ordinary shareholders.

The RPS will have a nominal value of $1.00 per share.

The holders of RPS do not have any voting rights.

The holders of RPS have no rights to the capital of the company.

The holders of RPS only have rights to dividend income (and franking credits).

There is no set date for the RPS to be redeemed and is likely that they will remain for a number of years.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 6-1

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 section 960-120

Income Tax Assessment Act 1997 Division 974

Reasons for decision

Question 1

Will the distributions (franked dividends) from the Company to the redeemable preference shareholders be treated as payments of dividends capable of being franked under section 202-40 of the ITAA 1997?

Answer: Yes.

Detailed reasoning

Division 974 of the ITAA 1997 provides for what constitutes 'equity' and what constitutes 'debt' in a company. It is necessary to determine if an interest is a debt or equity interest in order to appropriately treat distributions for income tax purposes.

Before we can answer the question about whether distributions are frankable, we need to determine if the redeemable preference shares are an equity interest or debt interest.

An equity interest is defined by section 974-70 of the ITAA 1997. A scheme gives rise to an equity interest in a company if, when the scheme comes into existence the scheme satisfies the equity test in subsection 974-75(1) of the ITAA 1997, in relation to the company because of the existence of an interest; and the interest is not characterised as, and does not form part of a larger interest that is characterised as, a debt interest in the company, or a connected entity of the company, under Subdivision 974-B of the ITAA 1997.

Section 974-15 of the ITAA 1997 defines the meaning of 'debt interest' for income tax purposes. A scheme gives rise to a debt interest in an entity if, when it comes into existence, it satisfies the "debt test" in relation to the entity.

Under subsection 974-70(1) of the ITAA 1997 a scheme gives rise to an equity interest where:

· the scheme satisfies one of the equity interest tests in the table in subsection 974-75(1) of the ITAA 1997; and

· the interest is not characterised as a debt interest under subdivision 974-B.

· Under subsection 974-15 a scheme gives rise to a debt interest where the debt test in section 974-20 is satisfied at the time the interest comes into existence.

The RPS will not be a debt interest because they fail to satisfy the elements of the debt test as set out in subsection 974-20(1) of the ITAA 1997. That is,

· there is no effectively non-contingent obligation on the part of the issuer to repay the investment amount under the RPS (required by paragraph 974-20(1)(c) of the ITAA 1997); and, as a result,

· it cannot be said that the requirements of paragraph 974-20(1)(d) of the ITAA 1997 will be met (that it is substantially more likely than not that the value of the financial benefit (defined in section 974-160 of the ITAA 1997) provided will equal or exceed the value of the financial benefit received).

As the interest is not a debt interest, if the redeemable preference shares can satisfy one of the items in table 1 of subsection 974-75(1) they will be characterised as an equity interest.

The value of the preference shares will be recorded in the financial statements as capital amounts. The distributions made to RPS shareholders will come out of the retained earnings of the profits. This suggests that any distributions are related to the economic performance of the company.

Item 2 of the table in subsection 974-75(1) of the ITAA 1997 treats an interest as being an equity interest if the return is contingent on the economic performance of the company. As was noted above, we believe that this is the case in your situation. Therefore, the RPS will be characterised as an equity interest.

As the redeemable preference shares are an equity interest we now need to determine if the distributions are frankable or not.

Section 960-120 of the ITAA 1997 provides for the meaning of 'distribution'. A distribution by a company is defined as 'a dividend, or something that is taken to be a dividend under this Act'.

Section 6-1 of the Income Tax Assessment Act 1936 (ITAA 1936) defines dividend as any distribution made by a company to any of its shareholders. However paragraphs (d), (e) and (f) outline amounts that are excluded from the definition of a dividend. The distributions made by the company to the redeemable preference share shareholders do not fall within the exclusions. Therefore, they will be classified as dividends for the purposes of the Income Tax Assessment Acts.

Section 202-40 of the ITAA 1997 defines a distribution to be frankable to the extent that it is not unfrankable as defined under section 202-45 of the ITAA 1997.

An analysis of the components of the section 202-45 of the ITAA 1997 determines that none of the paragraphs apply to the distributions made to the redeemable preference share shareholders. Therefore, as the distributions are not unfrankable under section 202-45 they must be frankable distributions under section 202-40 of the ITAA 1997.