ATO ID 2003/1104: Exempting entities: 'accountable membership interests'
Date of decision: 1 December 2003
Year of income: Year ended 30 September 2002 Year ended 30 September 2003 Year ended 30 September 2004 Year ending 30 September 2005 Year ending 30 September 2006 Year ending 30 September 2007
Business line: Public Groups and International

Issue
Are C Class shares which are beneficially owned by a resident company but subject to a call option which has been exercised by a non-resident company 'accountable membership interests' within the meaning of subsection 208-30(2) of the Income Tax Assessment Act 1997 (ITAA 1997) for the purposes of Division 208 of the ITAA 1997?

Decision
No. The C Class Shares are not accountable membership interests within the meaning of subsection 208-30(2) of the ITAA 1997 because they are excluded membership interests under subsection 208-30(3) of the ITAA 1997 due to the exercise of the call option.

Facts
An Australian resident company (the Entity) issued three classes of shares (being the A Class Shares, B Class Shares and C Class Shares). The A Class Shares (representing 5% of the share capital) carry 50% of the voting power, an entitlement to appoint 2 members of the Board of Directors, and a right to dividends 'pari passu'. The B Class Shares (representing 1% of the share capital) carry no voting power but have a right to dividends 'pari passu'. The C Class Shares (representing 94% of the share capital) carry 50% voting power, the right to appoint 1 member of the Board of Directors, and a right to dividends 'pari passu'. The C Class Shares were subscribed for by a non-resident company (Non-resident). Non-resident sold the C Class shares to an Australian resident company (Australian Purchaser). However, under the terms of the contract of sale the transfer of the legal title to the C Class Shares was not perfected such that Non-resident remained the registered holder of the C Class shares. Therefore, under Chang v. Registrar of Titles (1976) 137 CLR 177 Non-resident became trustee for Australian Purchaser under a constructive trust resulting from the contract of sale and payment of the Purchase Price. Non-resident was required, under the contract of sale, to deal with or account for any dividends or other distributions accruing to the shares for and on behalf of Australian Purchaser. Immediately after becoming the beneficial owner of the C Class Shares, Australian Purchaser gave Non-resident the right but not the obligation (the Call Option) to purchase the beneficial interest in the C Class Shares for a Settlement Amount equal to the Purchase Price. The Call Option was exercised by Non-resident with the result that upon settlement of the option, in five years time, Non-resident must pay the Settlement Amount to Australian Purchaser. On that date the beneficial interest in the C Class Shares will pass back to Non-resident.

Reasons for decision
Summary: Subsection 208-25(1) of the ITAA 1997 provides that an entity is effectively owned by prescribed persons at a particular time if at that time no less than 95% of the accountable membership interests or accountable partial interests in the entity are held by, or held indirectly for the benefit of, prescribed persons. Accountable membership interests are defined in subsection 208-30(2) of the ITAA 1997 as those membership interests that are not excluded membership interests. Accountable partial interests are similarly defined in subsection 208-35(2) of the ITAA 1997 as those partial interests that are not excluded partial interests. Excluded membership interests (or excluded partial interests) are those interests that, having regard to a number of factors listed in subsection 208-30(3) of the ITAA 1997 (or subsection 208-35(3) of the ITAA 1997 for partial interests) including the rights attaching to the interests and any arrangement in respect of those interests, it would be reasonable to conclude that the interest is not relevant in determining whether the entity is effectively owned by prescribed persons because holding the interest does not involve the holder bearing the risks, or result in the accrual to the holder of the opportunities, of ownership of the entity that ordinarily arise from, or ordinarily attach to, the holding of membership interests in the entity. In other words, an interest is excluded if, upon weighing the factors listed in subsection 208-30(3) of the ITAA 1997 (or subsection 208-35(3) of the ITAA 1997), a reasonable person would conclude that the interest does not expose the holder of that interest to the risks and opportunities that ordinarily arise from share ownership. The risks and opportunities that ordinarily arise from share ownership are those that expose the holder of the interest to the performance of the company. Some of the indicia of share ownership include that the holder has a right to dividends in the event the company is profitable and the directors declare them, the holder has voting rights in proportion with his or her interest in the company and that the value of the shares broadly track the performance of the company (that is, the holder is exposed to capital risk). In this case the effect of the contract of sale and call option is that the C Class Shares do not involve either Australian Purchaser or Non-resident bearing the risks or accruing the opportunities of ownership of the Entity that ordinarily attach to share ownership. Although Non-resident is exposed to the capital risk attaching to the interest, it does not benefit from the voting or dividend rights for five years. Similarly, Australian Purchaser does not participate to the same extent in the risks and opportunities of share ownership because the capital risk is borne by Non-resident. Australian Purchaser's capital investment in the Entity is effectively protected by the call option. Therefore, the C Class Shares are excluded membership/partial interests within the meaning of subsections 208-30(3) and 208-35(3) of the ITAA 1997 and therefore not accountable membership/partial interests for the purposes of Division 208 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 Division 208 subsection 208-30(2) subsection 208-30(3) subsection 208-25(1) subsection 208-35(2) subsection 208-35(3)
Case references: Chang v. Registrar of Titles (1976) 137 CLR 177
Subject references: Company tax Franking accounts Franking credits Imputation system Call option