Edited version of your written advice

Authorisation Number: 1012638775034

Ruling

Subject: Debt/equity provisions

Issue 1

Whether the return payable to non-resident Noteholders is interest or a dividend for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) and Division 11A of the Income Tax Assessment Act 1936 ( ITAA 1936.

Question 1

Are the convertible notes, Facilities A and B, issued by company A a debt interest for the purpose of subsection 974-20(1) of the ITAA 1997?

Answer

No.

Question 2

Are the convertible notes, Facilities A and B, issued by company A an equity interest for the purpose of subsection 974-75(1) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

01 July 2012 to 30 June 2013

01 July 2013 to 30 June 2014

01 July 2014 to 30 June 2015

01 July 2015 to 30 June 2016

01 July 2016 to 30 June 2017

01 July 2017 to 30 June 2018

The scheme commences on:

Year ended 30 June 2013

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.

Company A is an Australian public company listed on the ASX. Company A and its subsidiaries raised finance to develop mining projects.

The D Group of companies provided finance in several facilities during the development and construction period, along with an equity injection. This ruling concerns Facilities A and B.

The Notes issued under the scheme are subject to the terms and conditions set out in the deeds and agreements between Company A and its subsidiaries and the D Group of companies.

Facility A is a Converting Note Facility with a limit of $A million. Facility B is a Converting Note Facility with a limit of $B million.

For both facilities:

• Company A has the right to convert the all the Notes, but not some only, between 18 months after the date of the relevant deed and the Maturity Date. Company A's right to convert the Notes is subject to regulatory conditions and, in the case of the D Group of companies, there being no unacceptable change of control of Company A.

D Group company, Company D1, incorporated in non DTA country, is stated to be the provider of Facilities A and B.

• The Maturity Date is 5 years after the date of shareholder approval.

• The funds have been fully drawn down. The borrowings, interest, fees and repayments are in cash. Interest can be capitalised during the Capitalisation Period.

• Interest is payable on the Notes.

• The Principal Amount means, in respect of each Note at any time, the outstanding principal amount of that Note (other than a Note that has been converted or redeemed) including any interest that has been capitalised.

• The Conversion in effect on the Issue Date for a Note is:

(i) for Notes issued as Facility A Notes: AUD fixed amount per Share; and

(ii) for Notes issued as Facility B Notes: the Current Market Price per Share.

• The conversion price may be adjusted after certain events such as payment of dividends, bonus issues of shares, etc.

Relevant legislative provisions

Division 974 Income Tax Assessment Act 1997

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

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

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

Section 974-75) of the Income Tax Assessment Act 1997

Section 974-135 of the Income Tax Assessment Act 1997

Subsection 974-160(1) of the Income Tax Assessment Act 1997

and

Division 11A Income Tax Assessment Act 1936.

ATO view documents

Taxation Ruling 2008/3

Reasons for decision

Summary

The Convertible Notes issued by the Issuers do not satisfy the debt test as found in subsection 974-20(1) of the ITAA 1997.

Additionally, the Convertible Notes issued by the Issuers satisfy the equity test contained in subsection 974-70(1) of the ITAA 1997.

Therefore, the Convertible Notes issued by the Issuers are an equity interest for the purposes of Division 974 of the ITAA 1997. Withholding tax due on payments to the Noteholders should be calculated on the basis the payments are dividends.

Question 1

Debt test

The debt test is contained in subsection 974-20 of Subdivision 974-B of the ITAA

1997. Subsection 974-20(1) states:

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

(a) 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

(b) 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).

Scheme is a 'financing arrangement'

Company A and its subsidiaries entered into the agreement to issue the Convertible Notes to fund mining projects. In this regard, the scheme which Company A and its subsidiaries has entered into constitutes a 'financing arrangement' for Company A and will therefore satisfy paragraph 974-20(1)(a) of the ITAA 1997.

The interest arising from the scheme does not meet the criteria in item 1 of the table in subsection 974-75(1) of the ITAA 1997.

The entity or a connected entity receives a '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;'

The subsidiaries of Company A will receive the financial benefit, being the borrowings from Facilities A and B.

The entity 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 issuer's 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'.

The Commissioner's view is expressed in TR 2008/3: Income Tax: debt/equity - identification of any 'effectively non-contingent obligation' of an issuer of a convertible note to provide 'financial benefits' for the purposes of Division 974 of the ITAA 1997 if the note can be converted at any time at the issuer's discretion into shares that are equity interests in the issuer company which states:

37. The reason for having an effectively non-contingent test rather than simply a formal contingency test is further explained at paragraph 2.178 of the EM as follows:

2.178 ... In this regard, reliance solely on a formal non-contingent test would enable taxpayers to easily impose artificial contingencies in order to prevent an interest being debt. In addition, consistent with the principle inherent in the debt test of focusing on economic substance rather than legal form, where a contingency is so remote as to be effectively inoperative (immaterially remote) it is as if the contingency did not exist and it should be disregarded.

38. Therefore, where the provision of a financial benefit on an instrument is formally subject to a contingency, that formal contingency may be disregarded if, upon consideration of the pricing terms and conditions of issue of an instrument, the substance or effect of the arrangement is that the financial benefit will be provided by the issuer, despite the formal contingency. Artificial or contrived contingencies may be disregarded (subsection 974-135(6)). A contingency that is immaterially remote, as explained above, will be disregarded.

...

49. In the convertible note considered in this Ruling, the issuer only ever has a contingent obligation under section 974-135 to repay the issue price of the note, because at any time it can choose not to repay that amount by instead converting the note into a share that is an equity interest in the issuer. The obligation to pay interest on the convertible note is similarly contingent. In these circumstances, there is no effectively non-contingent obligation at any time under section 974-135 to provide financial benefits in any form that (for the purposes of Division 974) are substantially more likely than not to repay the investment.

The terms of issue of the Notes provide for:

Interest is payable on the Notes;

The redemption of the Notes:

(i) at their Principal Amount, at the option of Company A,

(ii) under the partial redemption provisions, and

(ii) The Issuers may voluntarily partially redeem the Notes prior to the Maturity Date.

Company A or its subsidiaries may purchase Notes on the open market.

The conversion of all the Notes into ordinary shares by Company A except in certain circumstances.

The issuance of Shares by Company A will constitute a complete Redemption of the Notes on the Conversion Date.

The following financial benefits are therefore payable under the Notes:

• Interest,

• Amount payable on redemption of the Notes for their Principal Amount,

• The partial redemption payments, and

• Voluntary redemption payments.

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).

Under the relevant deeds and agreements, a Note bears interest from the Issue Date, the rate of interest is defined, payment of interest is to be made by the due date and the Issuers can elect to capitalise interest during the Capitalisation Period and add it to the Principal Amount of that Note.

The Issuers agree to pay partial redemption payments.

For the first 18 months of their issue, the Notes are not convertible. In that period, the Interest payments and the Amortisation payments are non-contingent obligations.

Company A has the right to convert all the Notes (in accordance with certain conditions) after the first 18 months. The financial benefits payable under the Notes from that time are contingent on the non-conversion of the Notes from that time.

TR 2008/3, paragraph 44 states:

If the issuer of the convertible note can exercise its discretion at any time to convert the note into an equity interest in itself, the issuer can terminate at any time the requirement to provide financial benefits. Therefore, at the time of issue the provision of any financial benefits by the issuer will be contingent on the issuer's discretion to convert.

TR 2008/3 provides that the formal contingency can be disregarded if having regard to the price, terms and conditions of the Notes, the substance of the arrangement is that the financial benefits will be provided by the issuer.

The price of conversion for Facility A is a set price and for Facility B is a current market price.

Conversion means all outstanding Notes must be converted. This would give the D Group around 50% of the shares in Company A and effective control of the company. However the General Meeting of Company A approved the issue of the Convertible Notes to D Group under Facilities A and B. Neither conversion of the Notes at these prices nor the provision that all Notes must be converted means that conversion is an 'immaterially remote' contingency in accordance with TR 2008/3.

Company A may consider other courses of action other than conversion of the Notes, such as capital raisings or borrowing from third parties at more favourable rates and these outcomes may be possible with the development of the mines and favourable commodity prices, however these possibilities do not mean conversion of the Notes is 'immaterially remote'.

There are no other elements of the price, terms and conditions which suggest that the economic substance of the scheme means that the likelihood of conversion is 'immaterially remote'.

Therefore, the Interest payments and the Amortisation payments payable in the first 18 months are Company A's only effectively non-contingent obligations to provide financial benefits to the Noteholder under paragraph 974-20(1)(c ) of the ITAA 1997.

The value provided and the value received

For the first 18 months, Company A is obliged to pay the interest at the Rate of Interest.

However, the amounts payable under these obligations will not be at least equal to the value received. That is, there is no obligation to provide an amount that is at least equal to the issue price of the notes.

Therefore, the scheme will not satisfy the debt test pursuant to paragraph 974-20(1)(d) of ITAA 1997.

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

Summary

As Company A and its connected entities, for the first 18 months of the scheme, do not satisfy the fourth element of the debt test and, for the subsequent period, are able to satisfy their obligations under the scheme by the issue of shares and therefore have no effectively non-contingent obligation to provide financial benefits, the test for a debt interest is not satisfied.

Question 2

The equity test

The table in section 974-75(1) of the ITAA 1997 provides the test for an equity interest.

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

The Convertible Notes are not recorded as share capital of Company A and do not confer voting rights.

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 the amount invested in the interest.

Periodic payments of cash are contingent on the economic performance of Company A and its connected entities. The Convertible Notes satisfy this criterion.

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 the amount invested in the interest.

The Convertible Notes do not satisfy this criterion.

4. An interest issued by a 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 to an equity interest in the company or a connected entity of the company.

The Convertible Notes may be converted into shares by Company A.

The Convertible Notes satisfy the equity test in subsection 974-75(1) of the ITAA 1997.

Conclusion

As the Convertible Notes are classified as equity under Subdivision 974-C of the ITAA 1997, but are not classified as debt under Subdivision 974-B of the ITAA 1997, they will be treated as equity.