ATO ID 2003/900: Debt/Equity: whether converting preference shares are an equity interest or a debt interest
Date of decision: 26 September 2003
Year of income: Year ended 30 June 2004
Business line: Finance and Investment centre of Expertise.

Issue
Are converting preference shares issued by an entity an equity interest under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. The converting preference shares are an equity interest since the converting preference shares are shares in legal form and therefore they satisfy the equity test in subsection 974-75(1) of Subdivision 974-C of Division 974 of the ITAA 1997. The converting preference shares do not impose an effectively non-contingent obligation on the entity to provide a financial benefit. They fail the debt test in Subdivision 974-B of Division 974 of the ITAA 1997 and are not debt interests. Therefore the converting preference shares issued by the entity create an equity interest in the entity under subsection 974-70(1) of Subdivision 974-C of Division 974 of the ITAA 1997.

Facts
A bank issues converting preference shares on 1 July 2001 at an issue price of $100 each. Dividends are paid annually at 7.25% of the issue price at the same time that dividends on ordinary shares are paid. Five years after their issue date, each converting preference share mandatory converts into four ordinary shares of the bank. Each ordinary share has a par value of $25.

Reasons for decision
Summary: For instruments issued on or after 1 July 2001, Division 974 of the ITAA 1997 provides rules that govern the classification of debt and equity interests for tax purposes. Since the converting preference shares are shares in legal form they give rise to a membership interest. Item 1 of the table contained in subsection 974-75(1) of Subdivision 974-C of Division 974 of the ITAA 1997 is satisfied and the converting preference shares satisfy the equity test. However, paragraph 974-70(1)(b) of the ITAA 1997 provides that despite satisfying the equity test in subsection 974-75(1), a scheme cannot give rise to an equity interest if it is also characterised as, or forms part of a larger interest that is characterised as, a debt interest by application of the debt test. The debt test is contained in subsection 974-20(1) of Subdivision 974-B of Division 974 of the ITAA 1997. For the converting preference shares, the debt test will be satisfied if there is a 'scheme' which is a financing arrangement for the entity, and under which: The arrangement between the bank and the holder in relation to the converting preference shares falls within the ambit of a scheme, which is defined very broadly in subsection 995-1(1) of the ITAA 1997 to include 'any arrangement'. The bank receives a financial benefit under the arrangement to the extent of the $100 paid for each converting preference share purchased by the holder. The payment of an annual dividend on the converting preference shares is contingent on the availability of profits to the bank; therefore the bank does not have an effectively non-contingent obligation to pay dividends. Furthermore, the conversion after five years of the preference shares into ordinary shares is not a financial benefit since paragraph 974-30(1)(a) of the ITAA 1997 provides that an issue of an equity interest in an entity does not constitute the provision of a financial benefit by the entity. Since the only financial benefit that Division 974 of the ITAA 1997 recognises in this arrangement is the dividend, the payment of which is not effectively non-contingent, the converting preference shares fail the debt test in subsection 974-20(1) of Subdivision 974-B of Division 974 of the ITAA 1997. Therefore, the converting preference shares are an equity interest under subsection 974-70(1) of Subdivision 974-C of Division 974 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 subsection 974-5(4) subsection 974-20(1) paragraph 974-30(1)(a) subsection 974-70(1) paragraph 974-70(1)(b) subsection 974-75(1) subsection 995-1(1)
Subject references: Financial instruments Preference shares Debt equity borderline