Edited version of private advice

Authorisation Number: 1051787444730

Date of advice: 7 December 2020

Ruling

Subject: Characterisation of a convertible loan note

Question 1

Will the Convertible Loan Note (CLN) issued by Company A to Company B be treated as a debt interest pursuant to section 974-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes, the CLN issued by Company A to Company B will be treated as a debt interest pursuant to section 974-20 of the ITAA 1997.

Relevant facts and circumstances

Company A is an Australian incorporated and tax resident company, and the head entity of a tax consolidated group.

In year X, Company A sought to raise additional operational funding through an equity capital raising and the execution of a Convertible Note Deed (CND) with Company B.

Company B is a shareholder in Company A and at all times held less than a majority of all the issued shares in Company A.

Company B subsequently subscribed for the CLN pursuant to the CND and was issued the CLN upon payment of the Subscription Amount.

The Convertible Note is an unsecured debt obligation of Company A

The Convertible Note does not provide for any voting rights at the Company's Shareholder meetings.

At Company A's election, interest may accrue on the Principal Outstanding of the Convertible Note.

The Noteholder may elect to fully convert it on the terms set out in the CND.

If the Noteholder has not elected to convert the CLN before the Maturity Date, Company A must redeem the CLN in cash (principal outstanding plus any accrued and unpaid interest).

The Maturity Date is defined as being Y years from the date of issue unless previously redeemed or converted, where Y is less than 10 years.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 974-10

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

Income Tax Assessment Act 1997 section 974-20

Income Tax Assessment Act 1997 section 974-35

Income Tax Assessment Act 1997 subsection 974-70(1)

Income Tax Assessment Act 1997 subsection 974-70(2)

Income Tax Assessment Act 1997 section 974-75

Income Tax Assessment Act 1997 section 974-130

Income Tax Assessment Act 1997 section 974-135

Income Tax Assessment Act 1997 section 974-155

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Will the Convertible Loan Note (CLN) issued by Company A to Company B be treated as a debt interest pursuant to section 974-20 of the ITAA 1997?

Summary

Yes, the CLN issued by Company A to Company B will be treated as a debt interest pursuant to section 974-20 of the ITAA 1997.

Detailed reasoning

Division 974 of the ITAA 1997 provides statutory tests to determine whether an interest that arises from a scheme that is a financing arrangement should be characterised as a debt or equity interest for tax purposes.

Subsection 995-1(1) of the ITAA 1997 states that a debt interest in an entity has the meaning given by Subdivision 974-B.

In Subdivision 974-B of the ITAA 1997, subsection 974-15(1) states:

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.

The debt test

Subsection 974-20(1) of the ITAA 1997 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

(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.

Identifying the relevant scheme

Scheme is defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a) any ^* arrangement; or

(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

The Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001, at paragraph 2.22, states that:

It is a question of fact depending on all the relevant circumstances whether a series of transactions are part of a single scheme or constitute more than one scheme. Merely because transactions are undertaken under one agreement does not necessarily mean that they are all part of the one scheme.

In determining whether the relevant scheme consists of the execution of the CND and the issuance of the CLN, or just the drawing down of the funds, regard should be had to ATO ID 2006/230 Income Tax Revolving credit facility: Facility Agreement - debt interest (ATOID 2006/230). In ATOID 2006/230, a borrower entered into a syndicated loan facility agreement with lenders who committed to advance funds in staged drawdowns up to an agreed credit limit, provided certain pre-requisites were met. The Commissioner considered that:

[W]hile it could be argued that the entering into the Facility Agreement by the Borrower will constitute a scheme under this wide definition, the scheme would not of itself be a scheme that satisfies the debt test at the date it comes into existence, as required by subsection 974-15(1) of the ITAA 1997. For example, at the instance the Facility Agreement is entered into there would not exist any effectively non-contingent obligations between either of the parties to the arrangement. Rather, it will be the 'action' of drawing down the Advance in accordance with the terms of the Facility Agreement that will be the 'scheme' that is tested to see if that drawdown passes the debt test.

Applying the same reasoning, while it could be argued that entering the CND will constitute a scheme, it would not of itself be a scheme that satisfies the debt test at the date it comes into existence, because at that point in time, neither party had an effectively non contingent obligation to provide a financial benefit.

Accordingly, the scheme that will be tested to see if it passes the debt test will commence when Company A received the subscription amount and issued the CLN to Company B.

Is the scheme a financing arrangement?

In determining whether the scheme satisfies the debt test, the next item to consider is paragraph 974-20(1)(a) of the ITAA 1997, which is that the scheme is a 'financing arrangement' for the entity. Relevantly, under subsection 974-130(1) of the ITAA 1997, a scheme is a 'financing arrangement' for an entity if it is entered into or undertaken to, inter alia, 'raise finance for the entity (or a connected entity of the entity)' (paragraph 974-130(1)(a) of the ITAA 1997).

Company A issued the CLN to raise finance to fund its operations. It is therefore a financing arrangement and paragraph 974-20(1)(a) of the ITAA 1997 is satisfied.

Has the entity received, or will it receive a financial benefit under the scheme?

Paragraph 974-20(1)(b) of the ITAA 1997 requires that the entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme.

Subsection 974-160(1) of the ITAA 1997 states:

In this Act:

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.

The financial benefit received by Company A is the amount of money advanced to it under the CLN. Accordingly, Company A has received a financial benefit under the scheme and paragraph 974-20(1)(b) of the ITAA 1997 is satisfied.

Is there an effectively non-contingent obligation to provide financial benefits?

Paragraph 974-20(1)(c) of the ITAA 1997 requires the entity to have, or the entity and a connected entity of the entity to each have, 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(s) referred to in paragraph 974-20(1)(b) of the ITAA 1997 is or are received.

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) states:

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 defines 'non-contingent' to mean:

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.

At the time Company A receives the financial benefit from the Noteholder under the scheme, it is obligated to provide the following financial benefits to the Noteholder:

•         interest on the Principal Outstanding of the Convertible Note; and

•         redemption of the Convertible Note in cash to the Noteholder (if the Noteholder has not elected to convert the Note before the Maturity Date).

The obligation of Company A to pay the Redemption Amount (which includes the Principal Outstanding and any accrued and unpaid interest is not contingent on any event, condition, or situation. Further, subsection 974-135(4) of the ITAA 1997 provides that:

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.

The fact that the Noteholder, Company B, may elect (in its sole discretion) to convert the CLN to ordinary shares in Company A, does not make Company A's obligation not effectively non-contingent. Accordingly, Company A will have an effectively non-contingent obligation to provide the financial benefits constituted by the Redemption Amount to the Noteholder after the time which the financial benefit referred to above in relation to paragraph 974-20(1)(b) of the ITAA 1997 is received. Therefore, paragraph 974-20(1)(c) of the ITAA 1997 is satisfied.

Will the value provided be at least equal to the value received?

Paragraph 974-20(1)(d) of the ITAA 1997 requires that it be substantially more likely than not that the value provided will be at least equal to the value received. The value provided is defined in subsection 974-20(2) of the ITAA 1997 as:

(a)   the value of the *financial benefit to be provided under the *scheme by the entity or a *connected entity if there is only one; or

(b)   the sum of the values of all the financial benefits provided or to be provided under the scheme by the entity or a connected entity of the entity if there are 2 or more.

The value received is defined in subsection 974-20(3) of the ITAA 1997 as:

(a)   the value of the *financial benefit received, or to be received, under the *scheme by the entity or a *connected entity of the entity if there is only one; or

(b)   the sum of the values of all the financial benefits received, or to be received, under the scheme by the entity or a connected entity if there are 2 or more.

Further, subsection 974-20(4) of the ITAA 1997 provides that for the purposes of paragraph (1)(b) and subsections (2) and (3):

(a)   a *financial benefit to be provided under the *scheme by the entity or a *connected entity is taken into account only if it is one that the entity or connected entity has an *effectively non-contingent obligation to provide; and

(b)   a financial benefit to be received under the scheme by the entity or a connected entity is taken into account only if it is one that another entity has an effectively non-contingent obligation to provide.

Last, for the purposes of this Subdivision, paragraph 974-35(1)(a) of the ITAA 1997 provides that the value of the financial benefit provided or received is its value calculated:

(i) in nominal terms if the performance period (see subsection (3)) must end no later than 10 years after the interest arising from the scheme is issued; or

(ii) in present value terms (see section 974-50) if the performance period must or may end more than 10 years after the interest arising from the scheme is issued

The performance period is defined in subsection 974-35(3) of the ITAA 1997 as:

the period within which, under the terms on which the interest is issued, the *effectively non-contingent obligations of the issuer, and any *connected entity of the issuer, to provide a *financial benefit in relation to the interest have to be met.

The performance period of the CLN corresponds to the definition of 'Maturity Date' as defined in the CND, being a period of time from the date of issue, unless previously redeemed or converted. As this period of time is less than 10 years, the value of the financial benefits provided and received will be calculated in nominal terms, in accordance with subparagraph 974-35(1)(a)(i) of the ITAA 1997.

Given that Company A has an effectively non-contingent obligation to pay the Noteholder the establishment fee and interest in addition to the nominal value of the Convertible Note (i.e. the value received), it is substantially more likely than not that the value provided will be at least equal to the value received. Accordingly, paragraph 974-20(1)(d) of the ITAA 1997 is satisfied.

Related schemes

The object of Division 974 of the ITAA 1997 is to establish a test for determining, not only whether a scheme gives rise to a debt or equity interest, but also whether the combined operation of a number of schemes give rise to a debt or equity interest (subsection 974-10(1)). Subsection 974-10(3) explains that this is:

(a)   to ensure that the test operates effectively on the basis of the economic substance of the rights and obligations arising under the schemes rather than merely on the basis of the legal form of the schemes; and

(b)   to prevent the test being circumvented by entities merely entering into a number of separate schemes instead of a single scheme.

It is accordingly necessary to assess whether any other scheme is related to the scheme discussed above, and if so, their combined effect.

Section 974-155 explains the circumstances in which schemes are related to one another. It states that subject to subsection (3), two schemes are 'related to one another if they are related to one another in any way'. Subsections (2) and (3) further provide:

974-155(2)

Without limiting subsection (1), 2 *schemes are related to each other if:

(a)   the schemes are based on stapled instruments; or

(b)   one of the schemes would, from a commercial point of view, be unlikely to be entered into unless the other scheme was entered into; or

(c)    one of the schemes depends for its effect on the operation of the other scheme; or

(d)   one scheme complements or supplements the other; or

(e)   there is another scheme to which both the schemes are related because of a previous application or applications of this subsection.

974-155(3)

Two *schemes are not related to one another merely because:

(a)   one refers to the other; or

(b)   they have a common party.

In the Applicant's circumstances, it is considered that the two schemes that need to be assessed are:

•         the scheme identified above, when Company A received the Subscription Amount and issued the CLN, and

•         the issuance of shares in Company A under the equity raising.

Are the two identified schemes related?

As the issuance of the CLN to Company B occurred as a component of the broader capital raising including the equity raising, it could be said that the two schemes relate to one another.

Do the related schemes give rise to an equity interest?

Under subsection 974-70(2) of the ITAA 1997 two or more related schemes (the constituent schemes) are taken together to give rise to an equity interest in a company if:

(a)   the company enters into, participates in or causes another entity to enter into or participate in the constituent schemes; and

(b)   a scheme with the combined effect or operation of the constituent schemes (the notional scheme) would give rise to an *equity interest in the company under subsection (1) if the notional scheme came into existence when the last of the constituent schemes came into existence; and

(c)    it is reasonable to conclude that the company intended, or knew that a party to the scheme or one of the schemes intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest.

This is so whether or not the constituent schemes come into existence at the same time and even if none of the constituent schemes would individually give rise to that or any other equity interest.

On the facts, it is not reasonable to conclude that Company A intended, or knew that a party to the scheme intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest under paragraph 974-70(2)(c) of the ITAA 1997.

Company B is unrelated to the majority of other shareholders who subscribed for shares under the equity raising.

The terms of the CLN includes an effectively non-contingent obligation to repay the Principal Outstanding (which includes accrued interest not already paid), in full, which is typical of debt. The potential conversion of the Convertible Note to shares in Company A is at the full discretion of the holder of the CLN, not Company A.

The factual circumstances do not give rise to any sufficiently compelling reason or feature in order to arrive at the conclusion that is required for paragraph 974-70(2)(c) of the ITAA 1997 to apply.

The objective intention of the constituent schemes is supportive of a debt-equity funding mix for the capital raising rather than an objective intention that the combined economic effects be the same or similar to the economic effects of an equity interest. Therefore, paragraph 974- 70(2)(c) of the ITAA 1997 is not satisfied.

In conclusion, the CLN issued by Company A to Company B will be treated as a debt interest pursuant to section 974-20 of the ITAA 1997.