Edited version of your written advice

Authorisation Number: 1012970965943

Date of advice: 17 February 2016

Ruling

Subject: Debt vs Equity

Question 1

Will the Redeemable Preference Shares (RPS) be treated as an equity interest in the entity under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following periods:

1 July 2015 to 30 June 2016

The scheme commences on:

01 July 2015

Relevant facts and circumstances

The entity

The entity is a newly established company that is carrying on a Project.

The company sought investment funds by offering each investor Redeemable Preference Class shares (RPS) in the Company.

Capital structure of the Company

The company has two classes of shares on issue as follows:

• Ordinary shares

• RPS in the company issued at $1.00 each with a minimum subscription level.

The investors are to receive a scaled return based on the amount of their investment.

On completion of the Project, the company will redeem the shares issued to the Shareholder after repayment of all external debt and other secured creditors.

The scheme of Arrangement

The shares can be redeemed by the company at or prior to the redemption date, which is 24 months after the date of issue of the shares.

The company may redeem and the shareholder must surrender the RPS, and as consideration for such redemption and transfer, the company is obligated to pay the fixed divided return to each shareholder as set out in the Shareholders Agreement.

Redemption of the preference shares ranks ahead of any repayment of capital or dividends to ordinary shareholders in the company. Individual shareholders may obtain a replacement investor subject to the consent of the company.

There is a market risk associated with the scheme. There is a risk that the end value of the project may be less than current market value.

Other matters

Investors contributing funds to the company by way of RPS may not be able to recoup some or all of their investment in the event that the project is not completed within time or budget or the project declines in value from the time the project commences to completion of the project.

It is intended that the company will make a profit, however there can be no assurances that adverse political, economic or social changes will not cause the company to suffer a loss.

In the company constitution it outlines the rights of the holder of RPS are to:

• Receive a preferential or other dividend (whether cumulative or not) out of the profits of the company available for the payment of dividend, in priority to any other call of shares; and

• Receive on redemption and in a winding up payment of an amount in priority to any other class of shares;

Relevant legislative provisions

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 Section 974-70

Income Tax Assessment Act 1997 Section 974-75

Income Tax Assessment Act 1997 Section 974-135

Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision

Question 1

Summary

The RPS, are equity interests in the entity for the purposes of Division 974 of the ITAA 1997.

Detailed reasoning

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 RPS 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 of the ITAA 1997 and the interest is not a debt interest under section 974-20 of the ITAA 1997.

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:

In this case each RPS 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 item 2 of the table listed in subsection 974-75(1) of the ITAA 1997: i.e. it is an interest in the entity that carries a right to a fixed return from the company and the right is in substance or effect contingent on the economic performance of a part of the company's activities.

In this case the investor will receive a projected fixed scaled dividend return on completion of investment or part thereof and the projected return to investors will be on a scaled basis.

The interest carries a risk that the end value of the completed project may be less than the current market value. Should this occur, there is a risk that the projected profits anticipated by the project may not be achieved in part or in full and the payment of the fixed dividend and a return of capital to investors may be partially or completely lost.

As Item 2 is satisfied it is unnecessary, in the present context, to further consider whether any other Items in the table are also satisfied for the purposes of passing the equity test.

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

Debt test

Subsection 974-15(1) of the ITAA 1997 defines the meaning of a 'debt interest' as follows:

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).

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

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

• 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.

In order to satisfy the debt test, the scheme must satisfy all 5 limbs in subsection 974-20(1) of the ITAA 1997.

One of the key elements of the debt test is that a relevant entity, this will usually be the issuer, must have an 'effectively non-contingent obligation' under the scheme to provide a financial benefit or benefits.

An 'effectively non-contingent obligation' is defined at section 974-135 of the ITAA 1997.

Paragraphs 974-135(3),(4),(5) and (6) of the ITAA 1997 state that:

974-135 (3)

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 a connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation.

974-135(4)

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.

974-135(5)

An obligation to redeem a preference share is not contingent merely because there is a legislative requirement for the redemption amount to be met out of profits or a fresh issue of *equity interests.

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.

The debt test uses the concept of an effectively non-contingent obligation as opposed to a legally (or formally) non-contingent obligation. Thus a scheme under which an entity has a right but not a legal obligation to provide a financial benefit could nevertheless be debt if, having regard to the pricing, terms and conditions of the scheme, the entity is in substance or effect inevitably bound, to exercise that right.

The reason for having an effectively non-contingent test rather than simply a formal contingency test is explained at paragraph 2.178 of the Explanatory memorandum to the New Business Tax System (Debt and Equity) Act 2001 (EM) as follows:

178… in this regard, reliance solely on 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 did not exist and it should be disregarded.

In this case the RPS are not debt interests pursuant to subsection 974-20(1) of the ITAA 1997, on the basis that not all of the cumulative requirements under that provision are satisfied.

Paragraph 974-20(1)(a) of the ITAA 1997 is satisfied on the basis that the issue of the RPS constitutes a financing arrangement for the entity.

Paragraph 974-20(1)(b) of the ITAA 1997 is satisfied on the basis that the entity receives financial benefits in the form of the Issue Price of the RPS.

With respect to paragraph 974-20(1)(c) of the ITAA 1997, the entity does not have a effectively non-contingent obligation under the scheme to provide a financial benefit or benefit to their investors.

Although, the Information Memorandum (IM) outlines that there will be a projected fixed dividend return on completion or part thereof, including a scaled projected return to investors, this is not a guaranteed return.

The intention of the investment is to make a profit on the project however it says in the IM that there can be no assurance that adverse political, economic or social changes will not cause the company to suffer a loss.

In the IM it outlines that investing in a company as a preference shareholder carries a degree of risk. The project has a market risk associated with the particular scheme. The risk is that once completed the end value of the completed project may be less than their current market value.

The IM says that should this occur, there is a risk that the projected profits outlined to investors in the IM may not be achieved in part or in full and the payment of the fixed dividend and a return of capital to investors may be partially or completely lost.

Therefore, paragraph 974-20(1)(d) of the ITAA 1997 is also not satisfied because it is not substantially more likely than not that the value of the financial benefits which the entity has to provide its RPS shareholders will be at least equal to the value received.

As the scheme must satisfy all 5 limbs in subsection 974-20(1) of the ITAA 1997, it is immaterial whether paragraph 974-20(1)(e) is satisfied given that the conditions in paragraph 974-20(1)(c) and paragraph 974-20(1)(d) of the ITAA 1997 are not satisfied.

Conclusion

Based on the above, the RPS fail the debt test under section 974-20(1) of the ITAA 1997. Therefore, the RPS are equity interests under Division 974 of the ITAA 1997.