Edited version of your written advice

Authorisation Number: 1012856372931

Date of advice: 11 August 2015

Ruling

Subject: Investment in a proposed mandatory converting preference share (CPS) issue

Question 1

Will the CPS payment constitute a frankable distribution within the meaning of section 202-40 of the ITAA 1997?

Answer

Yes

Question 2

Will distributions on the proposed CPS give rise to a franking debit in the franking account of Entity B by operation of Item 1 of section 205-30 of ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

1 July 2015 to 30 June 2024

The scheme commences on:

Yet to commence

Relevant facts and circumstances

Scheme

Entity B is a private Australian resident company for income tax purposes.

Entity B proposes to undertake a capital raising by the issue of mandatory converting preference shares ("CPS") for an issue price of $X each.

The issue date for the CPS is unknown.

Reason for issuing the CPS

Entity B is a new company that has been specifically set up for investment purposes. Entity B forms part of a broad group of commercial interests associated with the family group.

It is the practice of the principals of the family group to establish separate entities to own each investment (or groups of investments). Funding for commercial activities is sourced from intra-group and external sources.

Entity B views mandatory CPS as cost effective equity finance. The issue of mandatory CPS is designed to raise capital on better terms than can be achieved through debt or ordinary equity. Therefore, for strategic commercial reasons the CPS provides an effective funding method for the medium to long term to make and manage investments over this time horizon.

A further benefit of the issue of CPS identified by the company is given the CPS do not carry the same voting rights as ordinary shares the control held by ordinary shareholders is not diluted upon issue of the CPS.

Main features of the CPS

The CPS are, fully paid, mandatorily convertible, subordinated, perpetual debt securities issued by Entity B in Australia.

The Issue Price and Face Value of each CPS is $X.

A Holder does not have voting rights at a general meeting.

The CPS will not be quoted on the ASX.

Distribution calculation

A Holder is entitled to receive, on the relevant Distribution Payment Date, a Distribution payable only in cash and calculated according to the following formula:

Distribution = [Distribution Rate * $X * N] / 365

where:

N is the number of days in the Distribution Period.

Distribution Rate (expressed as a percentage per annum) is calculated using the following formula:

Distribution Rate = RBA Official Rate + Margin

Margin to be set at the issue date based on prevailing market conditions

The Distributions are expected to be fully franked.

Distribution payment conditions

A distribution will be paid only if:

a) The Directors in their sole discretion resolve to pay the relevant Distribution on the relevant Distribution Payment Date; and

b) A Payment condition does not exist on the relevant Distribution Payment Date.

Distributions are non-cumulative and if all or any part of a Distribution is not paid, Holders have no claim or entitlement in respect of such non-payment and such non-payment does not constitute an event of default.

No interest accrues on any unpaid Distributions and the Holders have no claim or entitlement in respect of interest on any unpaid Distributions.

A Distribution is only payable on a Distribution Payment Date to the person registered as the holder of the CPS on the Record Date for that Distribution.

Terms of the CPS

The Holders may have their CPS Redeemed, Converted or Resold by Entity B according to the Terms.

Conversion

Conversion of the CPS involves the following:

(a) each Holder is issued a number of Ordinary Shares for each CPS that is being Converted on the Conversion Date equal to the Conversion Number

(b) each Holder's rights in relation to each CPS that is being Converted is immediately and irrevocably terminated for an amount equal to the Face Value and Entity B applies the Face Value by way of payment for the subscription of the Conversion Number of Ordinary Shares to be issued on Conversion.

Upon Conversion of the CPS, all other rights conferred or restrictions imposed on that CPS under the Terms no longer have effect (except for accrued rights).

Each Ordinary Share allotted upon Conversion ranks equally with all other fully paid Ordinary Shares.

Mandatory Conversion

All CPS must Convert into Ordinary Shares on the Mandatory Conversion Date.

Conversion, Redemption or Resale in other circumstances

The Issuer must convert, redeem or resell the CPS if a Tax Event or an Acquisition Event occurs.

In general these will occur if there is a material change in the tax laws or administration applicable to the issue of the CPS or if the Issuer proposes to sell more than 75% of the assets that it holds at the date of the issue of the CPS.

Ranking and subordination

CPS rank in respect of payment of Distributions:

(a) in priority to Ordinary Shares

(b) equally and without any preference amongst themselves and all Equal Ranking Instruments, and

(c) junior to the claims of all Creditors.

In a winding up of Entity B in Australia, a CPS confers upon its Holder, subject to the Terms, the right to a cash payment of the Face Value on a subordinated basis, but no further or other claim on Entity B.

The Holders rank for receipt of the Face Value in a winding up of Entity B:

(a) in priority to Ordinary Shares

(b) equally among themselves and with the claims of all Equal Ranking Instruments, and junior to the claims of all Creditors.

Relevant legislative provisions

Income Tax Assessment Act 1997, Division 197

Income Tax Assessment Act 1997, section 202-30

Income Tax Assessment Act 1997, section 202-40

Income Tax Assessment Act 1997, section 202-45

Income Tax Assessment Act 1997, subsection 205-30(1)

Income Tax Assessment Act 1997, Division 974

Income Tax Assessment Act 1997, subsection 974-15(1)

Income Tax Assessment Act 1997, section 974-20

Income Tax Assessment Act 1997, subsection 974-30(1)

Income Tax Assessment Act 1997, section 974-70

Income Tax Assessment Act 1997, section 974-75

Income Tax Assessment Act 1997, subsection 974-120(1)

Income Tax Assessment Act 1997, section 974-135

Income Tax Assessment Act 1997, paragraph 974-160(1)(a)

Income Tax Assessment Act 1997, subsection 995-1(1)

Reasons for decision

Question 1

Summary

The CPS, are equity interests as defined in section 974-75 of the ITAA 1997. The distributions under the CPS do not fall under any of the paragraphs in section 202-45 of the ITAA 1997. Therefore, the distributions of dividends from Entity B to the CPS Holders are capable of being franked under section 202-40 of the ITAA 1997.

Detailed reasoning

Paragraph 202-45(d) of the ITAA 1997 requires consideration of whether the interest is characterised as a debt or equity interest.

Equity test

Section 974-75 of the ITAA 1997 sets out the requirements for a scheme to satisfy the equity test in relation to a company.

The term 'scheme' is defined broadly in subsection 995-1(1) of the ITAA 1997 to mean any arrangement, scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. The issue of the CPS would fall within the definition of a scheme.

A scheme gives rise to an equity interest in the company under section 974-70 of the ITAA 1997 if the scheme satisfies the equity test in section 974-75 and the interest is not a debt interest under section 974-20.

A scheme satisfies the equity test in relation to a company if it gives rise to an interest of the kind listed in subsection 974-75(1) of the ITAA 1997 which are:

1 An interest in the company as a member or stockholder

2 An interest that carries a right to a variable or fixed return from the company where the right or the amount of the return is in substance or effect contingent on the economic performance (whether past, current or future) of the company or a "connected entity".

3 An interest that carries a right to a variable or fixed return from the company where the right or the amount of the return is at the discretion of the company or a connected entity.

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.

Each CPS will satisfy the equity test in subsection 974-75(1) of the ITAA 1997 as the interest arising from its issue is an interest covered by either or both of items 1 and 4 of the table listed in subsection 974-75(1).

Therefore, each CPS will be an equity interest unless they are characterised as debt interests under section 974-20 of the ITAA 1997.

Debt test

Subsection 974-20(1) of the ITAA 1997 provides that a scheme satisfies the debt test if:

a) it is a financing arrangement for the entity, and

b) the entity or a connected entity receives or will receive some financial benefit under the scheme, and

c) the entity has, or both the entity and a connected entity have, an effectively non-contingent obligation under the scheme to provide financial benefit(s) to one or more entities after the time when the first of the financial benefits in (b) above is received, and

d) it is substantially more likely than not that the value provided under (c) above will be at least equal to the value received under (b) above, and

e) the value provided and the value received are not both nil.

Scheme is a 'financing arrangement'

The scheme which Entity B has entered into for the issue of CPS 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 (3) provide is a financial benefit;'

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

Entity B will receive the 'issue price' of $X from the issue of each CPS. The total amount received by Entity B from the Holders who subscribed for the CPS will, therefore, constitute a 'financial benefit' for the purposes of paragraph 974-20(1)(b) of the ITAA 1997).

Issuing entity has an effectively non-contingent obligation to provide 'financial benefit'

The financial benefits that Entity B may provide to the holders of the CPS are as follows:

(1) Dividends:

There is no automatic right for convertible preference shareholders to participate in the profits or assets of Entity B. The company dividends (if any) are payable at the discretion of the directors of the company.

Accordingly, Entity B will not have an effectively non-contingent obligation to make the dividend payments in respect of each CPS.

(2) Issue price:

There is no obligation on Entity B to redeem the convertible preference shares for cash. Therefore, there is no effectively non-contingent obligation to provide a financial benefit to the holder in respect of the issue price of the convertible preference shares.

(3) Conversion:

The conversion of the CPS into Ordinary Shares does not constitute the provision of a financial benefit. Subsection 974-30(1) of the ITAA 1997 provides that the issue of an equity interest in the entity does not constitute the provision of a financial benefit.

As Entity B will not have an effectively non-contingent obligation to provide any financial benefits in respect of the CPS, the CPS have failed the debt test as they do not satisfy paragraph 974-20(1)(c) of the ITAA 1997.

The CPS issued by Entity B are considered to be equity interests as they satisfy the equity test in subsection 974-75(1) of the ITAA 1997. The CPS are not characterised as a debt interest as the requirements of subsection 974-20(1) are not satisfied.

Any dividends paid on the CPS will be a distribution in accordance with Item 1 in the table in subsection 960-120(1) of the ITAA 1997. Section 202-30 of the ITAA 1997 provides that distributions and non-share dividends are frankable unless it is specified they are unfrankable. Subsection 202-40(1) of the ITAA 1997 provides that a distribution is frankable to the extent that it is not unfrankable under section 202-45 of the ITAA 1997.

Section 202-45 of the ITAA 1997 specifically states:

The following are unfrankable:

(a) (Repealed by No 101 of 2003)

(b) a distribution to which paragraph 24J(2)(a) of the Income Tax Assessment Act 1936 applies that is taken under section 24J of the Income Tax Assessment Act 1936 to be *derived from sources in a prescribed Territory, as defined in subsection 24B(1) of the Income Tax Assessment Act 1936 (distributions by certain *corporate tax entities from sources in Norfolk Island);

(c) where the purchase price on the buy-back of a *share by a *company from one of its*members is taken to be a dividend under section 159GZZZP of that Act - so much of that purchase price as exceeds what would be the market value (as normally understood) of the share at the time of the buy-back if the buy-back did not take place and were never proposed to take place;

(d) a distribution in respect of a *non-equity share;

(e) a distribution that is sourced, directly or indirectly, from a company's *share capital account;

(f) an amount that is taken to be an unfrankable distribution under section 215-10 or 215-15;

(g) an amount that is taken to be a dividend for any purpose under any of the following provisions:

(i) unless subsection 109RB(6) or 109RC(2) applies in relation to the amount - Division 7A of Part III of that Act (distributions to entities connected with a *private company);

(ii) (Repealed by No 79 of 2007);

(iii) section 109 of that Act (excessive payments to shareholders, directors and associates);

(iv) section 47A of that Act (distribution benefits - CFCs);

(h) an amount that is taken to be an unfranked dividend for any purpose:

(i) under section 45 of that Act (streaming bonus shares and unfranked dividends);

(ii) because of a determination of the Commissioner under section 45C of that Act (streaming dividends and capital benefits);

(i) a *demerger dividend;

(j) a distribution that section 152-125 or 220-105 says is unfrankable.

Based on the facts of the case, paragraphs 202-45(b) and 202-45(c) of the ITAA 1997 are not applicable.

As a consequence of the conclusion reached above that, the CPS are, an equity interest, paragraph 202-45(d) of the ITAA 1997 will not apply.

For the purposes of this Ruling and based on the facts provided, the Commissioner has assumed that none of the requirements, listed in paragraphs 202-45(e) to 202-45(j) of the ITAA 1997, will apply to any future dividends that are paid by Entity B on the CPS. On this basis, it is therefore considered that any dividends paid on the CPS will not fall within the items listed in section 202-45 of the ITAA 1997.

The dividends paid in respect of the CPS will therefore be frankable distributions within the meaning of sections 202-30 and 202-40 of the ITAA 1997.

Question 2

Summary

Distributions on the proposed CPS will give rise to a franking debit in the franking account of Entity B.

Detailed reasoning

If a distribution on the CPS is a frankable distribution pursuant to sections 202-30 and 202-40 of the ITAA 1997 as outlined in Question 1, a franking debit will arise in the franking account of Entity B.

Item 1 of subsection 205-30(1) of the ITAA 1997 states if an entity franks a distribution a debit will arise in the franking account of the entity equal to the amount of the franking credit on the distribution. The franking debit will arise on the day on which the distribution is made.