Edited version of your private ruling

Authorisation Number: 1012585278779

Ruling

Subject: Capital Raising

Question 1

Will the Instrument be characterised as a 'non-share equity interest' for the purposes of the debt/equity rules in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will distributions payable in respect of the Instrument constitute frankable distributions under section 202-40 of the ITAA 1997 and not be unfrankable under section 202-45 of the ITAA 1997?

Answer

Yes.

Question 3

Will section 204-30 of the ITAA 1997 apply to the scheme?

Answer

No.

Question 4

Will section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the scheme?

Answer

No.

Relevant facts and circumstances

The transaction concerns the issuance of an Instrument by an Entity. The Instrument is convertible to ordinary shares in the Entity. Conversion will only happen if certain conditions are satisfied. The Instrument may also be redeemed or resold at face value in certain circumstances. Distributions on the Instrument are payable subject to certain conditions being satisfied. Distributions on the Instrument will be franked. Distributions payable in respect of the Instrument will not be debited to the Entity's share capital account or non-share capital account. The Instrument is being issued by the Entity to satisfy its financing requirements.

Relevant Provisions

• Section 177EA of the ITAA 1936;

• Section 202-40 of the ITAA 1997;

• Section 202-45 of the ITAA 1997;

• Section 204-30 of the ITAA 1997;

• Section 974-20 of the ITAA 1997; and

• Section 974-70 of the ITAA 1997.

Reasons for decision

Question 1

Summary

The Instrument will be characterised as 'non-share equity interest' for the purposes of the debt/equity rules in Division 974 of the ITAA 1997.

Detailed reasoning

Subsection 974-70(1) of the ITAA 1997 states that a scheme gives rise to an equity interest in a company if, when it comes into existence, it satisfies the equity test in subsection 974-75(1) of the ITAA 1997 and is not characterised as, and does not form part of a larger interest that is characterised as a debt interest under Subdivision 974-B of the ITAA 1997.

Paragraph 974-70(1)(a): The scheme must satisfy the equity test in subsection 974-75(1) in relation to the Entity

The equity test in subsection 974-75(1) of the ITAA 1997 is as follows:

A *scheme satisfies the equity test in this subsection in relation to a company if it gives rise to an interest set out in the following table:

Equity interests

Item Interest

1 An interest in the company as a member or stockholder of the company.

2 An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is in substance or effect *contingent on the economic performance (whether past, current or future) of:

(a) the company; or

(b) a part of the company's activities; or

(c) a *connected entity of the company or a part of the activities of a connected entity of the company.

The return may be a return of an amount invested in the interest.

3 An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of:

(a) the company; or

(b) a *connected entity of the company.

The return may be a return of an amount invested in the interest.

4 An interest issued by the company that:

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

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

Furthermore, subsection 974-75(2) of the ITAA 1997 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.

Scheme

A 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 as any arrangement, or any scheme, plan, proposal, action, course of action or conduct, whether unilateral or otherwise. The issue of the Instrument by the Entity constitutes a scheme.

The scheme gives rise to an interest set out in subsection 974-75(1) of the ITAA 1997

An equity interest in a company arises if an interest issued by the company will, or may, convert into an equity interest in the company or a connected entity of the company (item 4(b) of the table in subsection 974-75(1) of the ITAA 1997). The expression 'interest that will or may convert into another interest' has the meaning given in section 974-165 of the ITAA 1997:

An interest (the first interest) is an interest that will or may convert into another interest (the second interest) if:

(a) the first interest, or a part of the first interest, must be or may be converted into the second interest; or

(b) the first interest, or a part of the first interest, must be or may be redeemed, repaid or satisfied by:

(i) the issue or transfer of the second interest (whether to the holder of the first interest or to some other person); or

(ii) the acquisition of the second interest (whether by the holder of the first interest or by some other person); or

(iii) the application in or towards paying-up (in whole or in part) the balance unpaid on the second interest (whether the second interest is to be issued to the holder of the first interest or to some other person); or

(c) ….

The terms of the issue of the Instrument (Terms) provide for the conversion of the Instrument into ordinary shares in the Entity in certain circumstances. The conversion mechanism set out in the Terms is within the meaning of section 974-165 of the ITAA 1997. Furthermore, the ordinary shares issued on the conversion of the Instrument are equity interests in the Entity (item 1 of the table in subsection 974-75(1) of the ITAA 1997). Accordingly, the Instrument constitutes an interest that may convert into equity interests in the Entity and the scheme gives rise to an interest covered in item 4(b) of the table in subsection 974-75(1) of the ITAA 1997.

The scheme must be a financing arrangement

As the Entity enters into the scheme to raise finance for itself, the scheme is a financing arrangement within the meaning of paragraph 974-130(1)(a) of the ITAA 1997.

Therefore, the scheme satisfies paragraph 974-70(1)(a) of the ITAA 1997.

Paragraph 974-70(1)(b): The Instrument must not be characterised as debt interests in the Entity or a connected entity of the Entity under Subdivision 974-B of the ITAA 1997

Subsection 974-15(1) of the ITAA 1997 provides that:

A *scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) in relation to the entity.

Subsection 974-20(1) of the ITAA 1997 provides that:

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 scheme does not need to satisfy paragraph (a) if the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) (interest as a member or stockholder of the company).

(a) The scheme is a financing arrangement for the entity

As stated above, the scheme is a financing arrangement.

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

Paragraph 974-160(1)(a) of the ITAA 1997 states that a financial benefit includes 'anything of economic value'. Subsection 974-20(4) of the ITAA 1997 provides that a financial benefit received under the scheme is taken into account only if it is one that the other entity has an effectively non-contingent obligation to provide.

An 'effectively non-contingent obligation' is defined in subsection 995-1(1) of the ITAA 1997 to have the meaning given by section 974-135 of the ITAA 1997. Subsection 974-135(1) of the ITAA 1997 states that there is an effectively non-contingent obligation to take action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action. Subsection 974-135(3) of the ITAA 1997 further provides inter alia that an effectively non-contingent obligation is an obligation that is not contingent on any event, condition or situation other than the ability or willingness of that entity or a connected entity of the entity to meet the obligation.

The Terms state that the Entity will receive a financial benefit under the scheme, namely the issue price that the holders have an effectively non-contingent obligation to provide. Accordingly, this requirement of the debt test is satisfied.

(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.

Whilst a financial benefit includes anything of economic value, subsection 974-30(1) of the ITAA 1997 provides that the issue of an equity interest in the entity or a connected entity of the entity or an amount that is to be applied in respect of the issue of an equity interest in the entity or a connected entity of the entity does not constitute the provision of a financial benefit. Thus, the financial benefits to be provided by the Entity pursuant to the conversion mechanism in the Terms will not constitute the provision of a financial benefit by the Entity.

Consequently, in determining whether the Entity has an effectively non-contingent obligation under the scheme to provide a financial benefit, the relevant items of economic value (and therefore financial benefits), pursuant to section 974-135 of the ITAA 1997 are the obligations on the Entity to pay distributions on the Instrument and return any amount of the face value of the Instrument.

Obligation to pay distributions on the Instrument

The Entity does not have an effectively non-contingent obligation to provide a financial benefit by way of the distributions as payment of distributions is contingent on certain conditions being satisfied.

Obligation to return any amount of the face value of the Instrument

Redemption

The Terms set out the circumstances under which the Instrument may be redeemed. The circumstances in which redemption of the Instrument may occur do not suggest that the Entity has an effectively non-contingent obligation to provide a financial benefit. The occurrence of redemption is contingent on certain events occurring. The Entity does not have an effectively non-contingent obligation to provide a financial benefit in the form of the repayment of the face value of the Instrument on redemption.

Resale

The resale mechanism provided for in the Terms does not impose an effectively non-contingent obligation on the Entity to provide a financial benefit by way of returning the face value on the resale of the Instrument.

The above analysis demonstrates that the Entity does not have an effectively non-contingent obligation to provide a financial benefit by way of a distribution or return any part of the face value of the Instrument. The Entity therefore does not have an effectively non-contingent obligation to provide any financial benefit under the scheme. As the requirements of paragraph 974-20(1)(c) of the ITAA 1997 are not satisfied, the issue of the Instrument will not give rise to a debt interest in the Entity.

Conclusion

As the issuance of the Instrument satisfies the equity test in subsection 974-75(1) of the ITAA 1997 and does not meet the requirements to be characterised as a debt interest under Subdivision 974-B, it is treated as an equity interest in the Entity under Division 974 of the ITAA 1997. Each Instrument will constitute a 'non-share equity interest' as defined in subsection 995-1(1) of the ITAA 1997 as it is an equity interest in the Entity that is not solely a share.

Question 2

Summary

The distributions payable in respect of the Instrument will constitute frankable distributions under section 202-40 of the ITAA 1997 and not be unfrankable under section 202-45 of the ITAA 1997.

Detailed reasoning

Subdivision 202-C of the ITAA 1997 details the circumstances in which a distribution can be franked. Section 202-40 of the ITAA 1997 provides that distributions are frankable unless it is specified that they are unfrankable. Section 202-40 of the ITAA 1997 states:

(1) A *distribution is a frankable distribution, to the extent that it is not unfrankable under section 202-45.

(2) A *non-share dividend is a frankable distribution, to the extent that it not unfrankable under section 202-45.

As stated in the detailed reasoning for Question 1 above, each Instrument issued by the Entity is a non-share equity interest as defined in subsection 995-1(1) of the ITAA 1997. Distributions paid by the Entity in respect of each Instrument therefore constitute a 'non-share distribution' under section 974-115 of the ITAA 1997.

Section 974-120 of the ITAA 1997 provides that all non-share distributions will be non-share dividends, except to the extent to which the company debits the distribution against the company's non-share capital account or the company's share capital account. Distributions payable in respect of the Instrument will not be debited to the Entity's share capital account or its non-share capital account. Accordingly, the Distributions on the Instrument will constitute non-share dividends under section 974-120 of the ITAA 1997 and will be a frankable distribution to the extent that it is not unfrankable under section 202-45.

Section 202-45 of the ITAA 1997 sets out the circumstances under which an amount or distribution is taken to be unfrankable. Based on the facts and assumptions provided by the Applicant, it is considered that none of those circumstances will apply to the distributions made by the Entity on the Instrument.

Conclusion

Accordingly, the distributions payable in respect of the Instrument constitute frankable distributions under section 202-40 of the ITAA 1997 and are not unfrankable under section 202-45.

Question 3

Summary

Section 204-30 of the ITAA 1997 will not apply to the scheme.

Detailed reasoning

Section 204-30 of the ITAA 1997 is a general anti-streaming measure that applies if an entity streams distributions (or distributions and other benefits) in such a way that:

(a) an imputation benefit is, or apart from section 204-30 of the ITAA 1997 would be, received by a member of the entity as a result of the distribution(s); and

(b) the member would derive a greater benefit from franking credits than another member of the entity; and

(c) the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits.

Where these conditions are met, subsection 204-30(1) of the ITAA 1997 empowers the Commissioner to make one or more of the following determinations listed in subsection 204-30(3) of the ITAA 1997:

1. that a specified franking debit arises in the franking account of the entity, for a specified distribution or other benefit to a disadvantaged member;

2. that a specified exempting debit arises in the exempting account of the entity, for a specified distribution or other benefit to a disadvantaged member;

3. that no imputation benefit arises in respect of the relevant distribution that is made to a favoured member and specified in the determination.

Imputation benefit is defined in subsection 204-30(6) of the ITAA 1997 to include an entitlement to a tax offset under Division 207 of the ITAA 1997 as a result of the distribution. It is reasonable to expect that holders of the Instrument will receive an imputation benefit because the distributions payable in respect of the Instrument are frankable distributions.

The remaining issue is whether there will be a streaming of distributions in the way described in section 204-30 of the ITAA 1997. The expression 'streams' is not defined in the ITAA 1997. However, the Explanatory Memorandum (EM) to the New Business Tax System (Imputation) Bill 2002 (Cth), which introduced subdivision 204-D of the ITAA 1997 states at paragraphs 3.28 to 3.29 that:

3.28 Streaming is selectively directing the flow of franked distributions to those members who can most benefit from imputation credits.

3.29 The law uses an essentially objective test for streaming, although purpose may be relevant where future conduct is a relevant consideration. It will normally be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of members on the basis of their ability to use franking benefits is a key element of streaming.

Based on the information provided by the Applicant, it is considered that section 204-30 of the ITAA 1997 will not apply to the scheme.

Question 4

Summary

Section 177EA of the ITAA 1936 will not apply to the scheme.

Detailed reasoning

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies where one of the purposes (other than an incidental purpose) of a scheme is to enable a relevant taxpayer to obtain an imputation benefit. Where this purpose exists, subsection 177EA(5) of the ITAA 1936 empowers the Commissioner to make a determination that either:

(a) franking debits or exempting debits will arise in the franking account of a corporate tax entity that is the distributing entity and a party to the scheme; or

(b) no imputation benefit is to arise in respect of a distribution, or a specified part of a distribution, that flows directly or indirectly to the relevant taxpayer.

Pursuant to subsection 177EA(3) of the ITAA 1936, the provision applies if the following conditions are satisfied:

(a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and

(b) either:

(i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in membership interests, as the case may be; and

(c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

(d) except for section 177EA of the ITAA 1936, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

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

The conditions in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 are satisfied because:

(a) the issue of the Instrument constitutes a scheme for a disposition of membership interests (paragraph 177EA(3)(a) of the ITAA 1936);

(b) frankable distributions are expected to be payable to the holders of the Instrument in respect of the membership interest (paragraph 177EA(3)(b) of the ITAA 1936). The Commissioner accepts that distributions payable on the Instrument will be frankable distributions to the extent that the distributions on the Instrument do not fall within the list of unfrankable distributions in section 202-45 of the ITAA 1997;

(c) franked distributions are expected to be paid to holders of the Instrument (paragraph 177EA(3)(c) of the ITAA 1936); and

(d) it is reasonable to expect that an imputation benefit will be received by the holders of the Instrument (that is, the relevant taxpayers).

Accordingly, the issue is whether, having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer (i.e. the holder of the Instrument) to obtain an imputation benefit (paragraph 177EA(3)(e) of the ITAA 1936).

This is a test of objective purpose. Circumstances which are relevant in determining whether any person has the requisite purpose include, but are not limited to, the factors listed in subsection 177EA(17) of the ITAA 1936. The relevant circumstances listed encompass a range of circumstances which taken individually or collectively could indicate the requisite purpose. Due to the diverse nature of these circumstances, some may or may not be present at any one time in any one scheme.

Having regard to the factors listed in subsection 177EA(17) and the relevant circumstances of the arrangement, the Commissioner is of the opinion that the purpose of the scheme is to meet the Entity's financing requirements. Any imputation benefits obtained by the holders of the Instrument are considered incidental to this purpose.

Conclusion

Accordingly, section 177EA of the ITAA 1936 will not apply.