ATO ID 2003/873: Debt/Equity Interest: Redeemable Preference Shares - equity interest
Date of decision: 9 September 2003
Year of income: Year ended 30 June 2004
Business line: Finance and Investment Centre of Expertise

Issue
Will a distribution on redeemable preference shares (RPS), issued by a Company pursuant to its proposed constitution, be a frankable distribution, in so far as that depends on whether the RPS are an equity interest pursuant to Subdivision 974-C of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. A distribution from RPS held by a member of the Company in accordance with its proposed constitution may be frankable distributions pursuant to section 202-30 of the ITAA 1997 as the RPS constitute an equity interest pursuant to Division 974 of the ITAA 1997.

Facts
The Company operates in the finance industry and is regulated by the Australian Prudential Regulation Authority (APRA). The Company has issued to its Members shares only in the form of RPS. The Company is proposing to hold a meeting of its members where part of the business is to put to the members the proposed constitution to be adopted. A principle feature of the proposed constitution is the allowance of dividends to be paid to members who hold RPS (whenever the RPS were issued). The payment of dividends are subject to various conditions, including that there are sufficient profits out of which to pay them. The Company may pay dividends in the form of bonus shares which themselves have various conditions and rights as well as in the form of cash. In essence, the features, rights and obligations attached to the redemption of RPS are:

Reasons for decision
Summary: The RPS are equity interests as defined in subsection 974-70(1) of the ITAA 1997 because: It is necessary to consider the 'tie-breaker' provision outlined at subsection 974-5(4) of the ITAA 1997 to ascertain if the nature of the interest is also a debt interest, in which case the character of the interest will be taken as being a debt interest despite the fact that it is also an equity interest. An essential element (inter alia) in the debt test outlined in subsection 974-20(1) of the ITAA 1997 is that the effectively non-contingent obligations to provide a financial benefit by the entity (or entity and connected entity) under the scheme is equal to, or greater than, the financial benefit received by the (interest issuing) entity (or connected entity). The RPS will not be characterised as a debt interest because they fail to satisfy two elements of the debt test as set out in subsection 974-20(1) of the ITAA 1997. That is: Subsection 974-135(3) of the ITAA 1997 provides that 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 its connected entity), other than the ability or willingness of that entity or its connected entity to meet the obligation. The dividend payments associated with the RPS are not effectively non-contingent obligations of the issuer as they are contingent on the issuer having sufficient profits (economic performance). Where the form of dividend payment is by scrip (bonus) shares, subsection 974-30(1) of the ITAA 1997 provides that the issue of an equity interest in the entity (or connected entity) does not constitute the provision of a financial benefit. In respect of whether there is or is not an effectively non-contingent obligation on the part of the Company (issuer) vis-à-vis the RPS redemption, there is no such obligation because: Therefore, the Company will not have an effectively non-contingent obligation to redeem the RPS because redemption is at the option of the holder and there is no compulsion for the directors of the issuing Company to redeem the RPS at a specified date or time. Given that there is no established point in time where the issuing Company could be said to be under an obligation to redeem the RPS, if the holders do not elect to do so, the RPS may never be redeemed and no payment will ever eventuate. As a result of the issuing Company not having an effectively non contingent obligation to pay a dividend or redeem the RPS, it cannot be said that it is substantially more likely than not that the value of the financial benefits provided will equal or exceed the value of the financial benefits received (paragraph 974-20(1)(d) of the ITAA 1997). It is only the value of financial benefits that are effectively non- contingent obligations (paragraph 974-20(1)(c) of the ITAA1997) that are taken into consideration in determining whether the requirement in paragraph 974-20(1)(d) is satisfied. As the RPS do not meet the debt test, the nature of the interest would remain an equity interest with the consequence that any future distributions made by the Company on the RPS may constitute frankable distributions pursuant to section 202-30 of the ITAA 1997 and will not be deductible outgoings of the Company.

Legislative references: Income Tax Assessment Act 1997 section 202-30 Subdivision 974-B subsection 974-5(4) subsection 974-15(1) subsection 974-20(1) paragraph 974-20(1)(c) paragraph 974-20(1)(d) subsection 974-30(1) subsection 974-70(1) subsection 974-75(1) subsection 974-75(2) subsection 974-135(3) section 974-160 subsection 995-1(1)
Related ATO interpretative decisions: ATO ID 2003/200 | ATO ID 2003/527 | ATO ID 2003/665
Subject references: Debt interest Debt test Effectively non-contingent obligation Equity test Financing arrangement