Edited version of private advice

Authorisation Number: 1052088948483

Date of advice: 17 February 2023

Ruling

Subject: Taxation of financial arrangements

Question

Will Company X be entitled to a deduction under subsection 230-15(2) for a loss calculated in accordance with the balancing adjustment method statement in section 230-445, reflecting the premium paid to purchase a Note?

Summary

Pursuant to the test in section 230-55, each Note is a separate arrangement for the purposes of Division 230.

Each Note will satisfy the definition of a 'financial arrangement' as defined in section 230-45. Each Note is not a section 230-50 financial arrangement.

The balancing adjustment, equal to a loss amount calculated under subsection 230-445(1) (i.e., the amount the step 2 amount exceeds the step 1 amount) will be deductible under subsection 230-15(2); the loss being reflective of a premium paid to purchase a Note.

Answer

Yes.

This ruling applies for the following period:

Income year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

Overview

1.     Company X is an ASX listed company and an Australian resident company for income tax purposes.

2.     Company X is the head company of an Australian tax consolidated group.

3.     Company X raised debt capital by issuing $X of Convertible Notes due at a future period. (the Notes). The Notes are interest-bearing at the rate of X% per annum, payable semi-annually in arrears. Each Note was issued for $X and, unless redeemed or converted earlier, Company X is required to redeem each Note for $X on its maturity date at a future period.

4.     The holders of a Note have a right to convert the Note into ordinary shares in Company X.

5.     The Notes are listed on an international exchange. On issue, the Notes had a listed price of $X each and initially traded at par (i.e., 100% of the original value / face value of a Note).

6.     The trading value of the Notes increased significantly.

7.     Company X proposes buy-back some of the Notes on-market (the Buy-Back). If Company X buys back the Notes, the Notes will then be cancelled.

Terms and Conditions of the Notes

8.     The terms and conditions of the Notes are set out in the Offering Circular.

Set out below is a summary of the principal features of the Notes:

(a) Issuer

The Notes were issued by Company X

(b) Instrument

The Notes constitute $X X% Senior Convertible Notes due at a future period.

(c) Issue Price

The issue price of the Notes is equal to 100% of their Principal Amount (i.e., $X per Note).

(f) Interest

Each Note entitles the Holder to receive on the relevant Interest Payment Date a payment of interest in respect of that Note.

The Notes bear interest at a rate of X% per annum, payable semi.

(g) Redemption

Unless previously redeemed or converted in accordance with the Offering, the Notes will be redeemed at the Redemption Amount on the Maturity Date (that is, at a future period).

The Redemption Amount is the full principal amount of the relevant Note ($X), plus any interest accrued but unpaid to (but excluding) the relevant Redemption Date.

(h) Conversion Right

Holders are entitled to convert their Notes into Ordinary Shares (the Conversion Right). Subject to certain conditions, the Conversion Right may be exercised by the Holder at any time.

The number of Ordinary Shares each Holder is entitled to receive upon exercise of the Conversion Right is calculated by reference to the principal amount of the Notes to be converted, divided by a set price per Ordinary Share (the Initial Conversion Price).

Overview of the Buy-Back

9.     The Buy-Back will be undertaken on-market via Company X purchasing Notes currently trading on the international exchange.

10.  Due to the Notes currently trading significantly above their Issue Price, Company X will be required to pay a premium to the Issue Price when buying back the Notes (the Premium).

Other Facts

11.  Company X recognise the Notes as debt interests for Australian income tax purposes under Division 974.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 230-15

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 section 230-435

Income Tax Assessment Act 1997 section 230-440

Income Tax Assessment Act 1997 section 230-445

Income Tax Assessment Act 1997 section 230-55

Income Tax Assessment Act 1997 section 230-50

Income Tax Assessment Act 1997 section 230-85

Income Tax Assessment Act 1997 section 230-40

Income Tax Assessment Act 1997 section 995-1

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 section 974-70

Income Tax Assessment Act 1997 section 974-75

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise indicated.

Whether the Notes are an 'arrangement' for Division 230

12.  The TOFA provisions in Division 230 deal with the taxation treatment of gains and losses from financial arrangements.

13.  In order to determine whether gains and losses arise under a financial arrangement pursuant to the TOFA provisions, it is first necessary to identify the relevant 'arrangement'.

14.  An arrangement is broadly defined under subsection 995-1(1) to mean any arrangement, agreement, understanding, promise or undertaking whether expressed or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings.

15.  Section 230-55 provides grouping and disaggregation rules for the purpose of identifying an arrangement for TOFA purposes. Subsection 230-55(4) sets out the matters that need to be considered in determining whether a number of rights and/or obligations are themselves an arrangement or whether there are two or more separate arrangements.

16.  Subsection 230-55(4) provides:

(4) For the purposes of Division 230, whether a number of rights and/or obligations are themselves an *arrangement or are 2 or more separate arrangements is a question of fact and degree determined having regard to the following:

(a)  the nature of the rights and/or obligations;

(b)  their terms and conditions (including those relating to any payment or other consideration for them);

(c)  the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved);

(d)  whether they can be dealt with separately or must be dealt with together;

(e)  normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole);

(f)   the objects of this Division.

In applying this subsection, have regard to the matters referred to in paragraphs (a) to (f) both in relation to the rights and/or obligations separately and in relation to the rights and/or obligations in combination with each other.

Example 1:

Your rights and obligations under a typical convertible note, including the right to convert the note into a share, or shares, would constitute one arrangement

Example 2:

Your rights and obligations under a typical price-linked or index-linked bond would constitute one arrangement.

Note 1:

If you raised funds by means of a contract that you would not have entered into without entering into another contract, and neither contract could be assigned to a third party without the other also being assigned, this would tend to indicate that your rights and obligations under the 2 contracts together constitute one arrangement.

Note 2:

If the commercial effect of your individual rights and/or obligations in a group or series cannot be understood without reference to the group or series as a whole, this would tend to indicate that all of your rights and/or obligations in the group or series together constitute one arrangement.

17.  Taxation Ruling TR 2012/4 Income tax: the operation of subsection 230-55(4) of the Income Tax Assessment Act 1997 in determining what is an 'arrangement' for the purposes of the taxation of financial arrangements under Division 230 provides the Commissioner's view on the application of subsection 230-55(4).

18.  TR 2012/4 provides (at paragraph 6) that while it will often be the case that the arrangement is consistent with the legal form of the arrangement, subsection 230-55(4) can operate to identify as an arrangement something other than the rights and/or obligations under a particular contract. Whether a number of rights and/or obligations are themselves an arrangement, or are two or more separate arrangements, is a question of fact and degree that is determined having regard to the matters listed in paragraphs 230-55(4)(a) to (f), both in relation to the rights and/or obligations separately and in relation to the rights and/or obligations in combination with each other (TR 2012/4, paragraph 10).

19.  The weight given to each factor in subsection 230-55(4) depends on the circumstances of the particular case (TR 2012/4, paragraph 13).

20.  Having regard to the matters in subsection 230-55(4) in respect of Company X's rights and obligations under the Notes, the Commissioner considered and gave weight to the following matters:

•         whether each arrangement can be dealt with separately or whether they can be dealt with together.

o   each Note grants the holder a conversion right that may be exercised at any time. This factor points towards each Note being a separate arrangement.

•         that Example 1 under subsection 230-55(4) states that typical convertible note, including the right to convert the note into a share or shares, would constitute one arrangement.

o   the Notes give the holder a conversion right for ordinary shares upon exercise of the conversion option.

21.  Having regard to TR 2012/4, the matters in subsection 230-55(4) and example 1 to section 230-55, the Commissioner considers that each Note constitutes a separate arrangement for TOFA purposes.

Whether the 'arrangement' identified within Division 230 constitutes a 'financial arrangement', as defined in section 230-45, subsection 230-50(1) or subsection 230-50(2)

22.  For Division 230 to apply, the arrangement identified under section 230-55 must be a financial arrangement. A Division 230 financial arrangement pursuant section 230-45 is an arrangement where the rights and obligations under that arrangement are cash settable.

23.  Section 230-45 is the general test for a Division 230 financial arrangement. Section 230-50 provides a further two tests for determining a financial arrangement at subsection 230-50(1) and subsection 230-50(2).

24.  As provided above, each Note constitutes an arrangement for the purposes of section 230-55. Therefore, the relevant arrangement being tested under section 230-45, subsection 230-50(1) and subsection 230-50(2) is a Note.

Is a Note a section 230-45 financial arrangement?

25.  Pursuant to subsection 230-45(1), an entity will have a cash settlable financial arrangement where, under an arrangement there is:

230-45(1) (...)

(a)  a cash settlable legal or equitable right to receive a financial benefit; or

(b)  a cash settlable legal or equitable obligation to provide a financial benefit; or

(c)  a combination of one or more such rights and/ or one or more such obligations.

unless:

(d)  you also have under the arrangement one or more legal or equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and

(e)  for one or more rights and/or obligations covered by paragraph (d)

(i)     the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or

(ii)    the right or obligation is not cash settable; and

(f)   the one or more rights and/ or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c).

26.  The Explanatory Memorandum to Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (TOFA EM) provides at paragraph 2.6 that generally "...the time to determine whether an arrangement is a financial arrangement will be at the time the arrangement comes into existence or commences to be held...". At the time a Note came into existence, there were broadly three obligations for Company X; the semi-annual interest payments, the redemption of principal at maturity and the contingent obligation to convert a Note into shares if a Holder chooses to do so.

27.  These financial obligations that Company X has the obligation to provide under the arrangement need to be considered to determine whether they are 'cash settable'. Subsection 230-45(2) specifies the circumstances in which a right to receive or obligation to provide a financial benefit that you have is cash settlable. Relevantly, paragraphs 230-45(2)(a) to (g) provide:

230-45(2) A right you have to receive, or an obligation you have to provide, a *financial benefit is cash settlable if, and only if:

(a)  the benefit is money or a *money equivalent; or

(b)  in the case of a right - you intend to satisfy or settle it by receiving money or a money equivalent or by starting to have, or ceasing to have, another *financial arrangement; or

(c)  in the case of an obligation - you intend to satisfy or settle it by providing money or a money equivalent or by starting to have, or ceasing to have, another financial arrangement; or

(d)  you have a practice of satisfying or settling similar rights or obligations as mentioned in paragraph (b) or (c) (whether or not you intend to satisfy or settle the right or obligation in that way); or

(e)  you deal with the right or obligation, or with similar rights or obligations, in order to generate a profit from short-term fluctuations in price, from a dealer's margin, or from both; or

(f)   none of the paragraphs (a) to (e) applies but you satisfy subsection (3); or

(g)  you are able to settle the right or obligation as mentioned in paragraph (b) or (c) (whether or not you intend to satisfy or settle the right or obligation in that way) and you do not have, as your sole or dominant purpose for entering into the arrangement under which you are to receive or provide the financial benefit, the purpose of receiving or delivering the financial benefit as part of your expected purchase, sale or usage requirements.

A reference in paragraph (b) or (c) to a financial arrangement does not include a reference to something that is a financial arrangement under section 230-50.

28.  Company X's obligation to pay interest on the Note semi-annually and redeem the Note upon Final Redemption are clearly cash settlable obligations as these financial benefits are settled by providing money. However, Company X's obligation to provide Company X shares upon the exercise of a Conversion Right also needs to be considered.

29.  Section 230-85 provides that an obligation is treated as an obligation for the purposes of Division 230 even if it is subject to a contingency. The TOFA EM explains (at paragraph 2.65) that a contingent obligation to provide something upon the exercise of an option is an obligation for the purposes of subsection 230-45(2):

2.65 A right to receive, or an obligation to provide, a financial benefit for the purposes of Division 230 will exist irrespective of whether the value or existence of the right or obligation to the financial benefit is contingent on some event or other thing. For example, a party that issues an option assumes an obligation to provide a financial benefit, notwithstanding that the value or existence of the obligation is contingent on the exercise of the option. [Schedule 1, item 1, section 230-85]

30.  Under the terms of the Notes, Company X has an obligation to settle the Notes by providing the holder ordinary shares in Company X, contingent on the holder exercising their conversion right (the Conversion Right). Therefore, pursuant to section 230-85, this contingent obligation is an obligation for the purposes of section 230-45.

31.  While the obligation to provide Company X shares is not settled by the provision of money or a money equivalent, the obligation to provide ordinary shares where a conversion right (the Conversion Right) is exercised will be considered cash settable if paragraph 230-45(2)(f) is satisfied, which in turn requires subsection 230-45(3) to be satisfied. Subsections 230-45(3) and (4) state that:

230-45(3) You satisfy this subsection if:

(a)  the *financial benefit is readily convertible into money or a *money equivalent; and

(b)  there is a market for the financial benefit that has a high degree of liquidity; and

(c)   subsection (4) or (5) is satisfied.

230-45(4) This subsection is satisfied if, for the recipient of the *financial benefit, the amount of the money or *money equivalent referred to in paragraph (3)(a) is not subject to a substantial risk of substantial decrease in value.

32.  The Commissioner considers that subsection 230-45(3) is satisfied in respect of the obligation to provide Company X shares in the event a holder exercises their option to convert as:

•         the Company X shares are a financial benefit provided that are readily convertible into money or a money equivalent (paragraph 230-45(3)(a)), and

•         there is a market for the Company X shares that has a high degree of liquidity; noting Company X ordinary shares are traded on the ASX. This demonstrates that the shares can readily be converted to money if required (paragraph 230-45(3)(b)), and

•         the recipient of Company X shares upon exercise of the Conversion Right is not subject to a substantial risk of a substantial decrease in value (subsection 230-45(4)).

33.  Tax Laws Amendment (2010 Measures No. 4) Bill 2010 introduced amendments to the TOFA provisions that clarified the meaning of cash settlable. Paragraph 3.27 of the Explanatory Memorandum to Tax Laws Amendment (2010 Measures No. 4) Bill 2010 (TOFA EM#2) discussed the amendments in the context of convertible instruments. The paragraph explained that the amendments:

...clarifies that convertible and similar instruments will generally be financial arrangements. More broadly, it is consistent with the notion that in substance debt, even with upside potential (whether through convertibility or otherwise), should as a general principle be treated as a financial arrangement.

34.  The conclusion that a Note is a financial arrangement is also in accordance with the outcome provided in example 3.2 TOFA EM#2. The shares issued in that example upon a conversion of a convertible note are also listed on the ASX and the market for them is highly liquid.

35.  For Company X, subsection 230-45(4) is met. The financial benefit the holder of Note receives on exercising the Conversion Right is not subject to a substantial risk of substantial decrease in value. Though the Company X share price fluctuates as is expected with any security listed on the ASX, it is unlikely they are subject to substantial risk or decrease in value in nominal terms.

36.  It follows that a Note will be a financial arrangement of Company X under section 230-45 as all of the obligations provided under the arrangement constitute financial benefits that are cash settable.

Is a Note a section 230-50(1) financial arrangement?

37.  Subsection 230-50(1) provides that an equity interest is also a financial arrangement for TOFA purposes. Taxation Determination TD 2011/12 Income tax: where an equity interest is a financial arrangement which satisfies both subsections 230-45(1) and 230-50(1) of the Income Tax Assessment Act 1997, which provision applies? provides (at paragraph 10) that subsection 230-50(1) applies in preference to subsection 230-45(1).

38.  As such, in order to work out whether the arrangement is a financial arrangement under section 230-45, it is necessary to consider whether the arrangement also satisfies subsection 230-50(1).

39.  Subsection 230-50(1) provides:

You also have a financial arrangement if you have an *equity interest. The equity interest constitutes the financial arrangement.

40.  An equity interest has the meaning given by Subdivision 974-C in the case of a company.

41.  Pursuant to subsection 974-70(1), a scheme gives rise to an equity interest in a company if:

(a)  the scheme satisfies the equity test in subsection 974-75(1), and

(b)  the interest is not characterised as a debt interest under Subdivision 974-B.

42.  As set out in the 'Other Facts', Company X recognise the Notes as debt interests for income tax purposes under Division 974 on the basis that the tie-breaker provision in paragraph 974-70(1)(b) applies. That is, where both the debt and equity tests are satisfied, the interest is a debt interest.

43.  As such, the Notes do not meet the definition of an equity interest and as a result the Notes will not be a financial arrangement under subsection 230-50(1).

Is a Note a subsection 230-50(2) financial arrangement?

44.  An arrangement may also be financial arrangement under subsection 230-50(2) which provides:

You also have a financial arrangement if:

(a)  you have, under an *arrangement:

(i)     a legal or equitable right to receive something that is a financial arrangement under this section; or

(ii)    a legal or equitable obligation to provide something that is a financial arrangement under this section; or

(iii)   a combination of one or more such rights and/or obligations; and

(b)  the right, obligation or combination does not constitute, or form part of, a financial arrangement under subsection 230-45(1).

The right, obligation or combination referred to in paragraph (a) constitutes the financial arrangement.

45.  Under the Notes, Company X have a contingent obligation to provide Company X shares if a Conversion Right is exercised. As the ordinary shares in Company X are equity interests, Company X has a legal obligation to provide something that would otherwise be a financial arrangement under section 230-50. On this basis sub-paragraph 230-50(2)(a)(ii) would be satisfied.

46.  However, pursuant to paragraph 230-50(2)(b), subsection 230-50(2) only applies if the obligation does not form part of a financial arrangement under subsection 230-45(1).

47.  A set out above, a Note is a single financial arrangement that consists of the obligations identified, including the obligation to provide Company X shares in the event a Conversion Right is exercised. All of the obligations are cash settable financial benefits provided by Company X that collectively satisfy the definition of a financial arrangement under subsection 230-45(1). It follows that the obligation to provide Company X shares in the event of a Conversion Right being exercised cannot be a financial arrangement as defined in subsection 230-50(2).

48.  The Commissioner is therefore satisfied that a Note is a subsection 230-45(1) financial arrangement and not a subsection 230-50(1) or (2) financial arrangement. This means that the balancing adjustment provisions in Subdivision 230-G will apply to a Buy-Back of a Note without modification.

Balancing adjustment calculation under Subdivision 230-G and whether Company X entitled to deduction under subsection 230-15(2)

Balancing adjustment calculation under Subdivision 230-G

49.  A balancing adjustment under Subdivision 230-G applies when a taxpayer either transfers some or all of the rights and obligations under the arrangement to another person, or all of the taxpayer's rights or obligations under the arrangement otherwise cease.

50.  The TOFA EM provides (at paragraph 10.3) that a balancing adjustment may result in an additional amount of gain or loss brought to account on the disposal of a financial arrangement to ensure the correct amount of gain or loss is brought to account from holding and subsequently disposing of the financial arrangement. Amounts recognised prior to disposal are taken into account in working out any gain or loss on disposal. This corrects any previous under-allocation or over-allocation of a gain or loss before disposal.

51.  Pursuant to subsection 230-40(2), where the balancing adjustment under Subdivision 230-G is applied to take into account a gain or loss, that gain or loss cannot be taken into account under the accruals and realisation method set out in Subdivision 230-B

52.  Paragraph 230-435(1)(b) provides that a balancing adjustment is made under Subdivision 230-G if all your rights and/or obligations under a financial arrangement cease.

53.  Further, the relevant exceptions under section 230-440 do not apply to the Notes because, in particular:

•         a Note is not a financial arrangement under section 230-50 (i.e., paragraph 230-440(1)(a) does not apply), and

•         the cessation is happening because a Note is being brought back on-market and then cancelled rather than being converted into ordinary shares (i.e., the exclusion in paragraph 230-440(3)(c) for convertible interests that are ceasing because of a conversion event does not apply).

54.  The method statement in section 230-445 establishes the amount of the balancing adjustment by comparing: -

•         of all the financial benefits provided and amounts that have been, will be or would have been assessed that are attributable to the arrangement with

•         the financial benefits received and amounts that have been, will be or would have been deductible

Whether the amount is deductible under subsection 230-15(2)

55.  To determine whether a loss made from the Buy-Back of a Note is deductible under Division 230, the loss must satisfy the requirements of subsection 230-15(2). Subsection 230-15(2) provides:

You can deduct a loss you make from a *financial arrangement, but only to the extent that:

(a)  you make it in gaining or producing your assessable income; or

(b)  you necessarily make it in carrying on a *business for the purpose of gaining or producing your assessable income.

56.  The TOFA EM explains that the rule in subsection 230-15(2) reflects the general deduction rule in section 8-1:

3.70 Under Division 230, losses from financial arrangements are deductible to the extent that they are made in gaining or producing assessable income or are necessarily made in carrying on a business for the purpose of gaining or producing assessable income, unless otherwise specified. [ Schedule 1, item 1, subsection 230-15(2)]

3.71 This rule reflects the current general deduction rule in section 8-1 of the ITAA 1997 with the exception that it generally does not deny deductions for a loss of a capital nature. This is consistent with an object of Division 230, which is to generally ignore distinctions between capital and revenue. [ Schedule 1, item 1, subparagraph 230-10(b)(ii)]

...

3.72 ... the rule in subsection 230-15(2) reflects the current general deduction rule in section 8-1 of the ITAA 1997 - in particular the 'nexus' aspects of section 8-1. Hence, the case law in respect of the nexus aspects would also apply in determining whether losses made from a financial arrangement will satisfy the test for deductibility in subsection 230-15(2). ...

57.  The primary issue under section 8-1 is whether an entity has a 'loss or outgoing'. Similarly, subsection 230-15(2) requires that there be a 'loss' made from a financial arrangement.

58.  Loss is not defined, and as such it takes its ordinary meaning.

59.  The Commissioner is satisfied that the balancing adjustment loss is a loss necessarily incurred by Company X in carrying on its business for the purpose of gaining or producing assessable income pursuant to subsection 230-15(2).