ATO ID 2003/200: Debt/Equity: Redeemable Preference Share
Date of decision: 11 October 2002
Year of income: Year ended 31 December 2001
Business line: Finance and Investment Centre of Expertise

Issue
Will Redeemable Preference Shares (RPS), that are redeemable at the option of the issuer and provide for dividend returns that are contingent on profits, be characterised as debt interests pursuant to Subdivision 974-B of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
No, the RPS will not be characterised as debt interests pursuant to Subdivision 974-B of the ITAA 1997. The RPS will be characterised as an equity interest as defined in subsection 974-70(1) of the ITAA 1997.

Facts
The arrangement involves a company issuing RPS at a specified issue price with terms that provide for payment of a fixed cumulative dividend and redemption being at the discretion of the issuing company. Any dividends payable on the RPS are payable in priority to dividends paid to ordinary shareholders. Where the directors of the issuing company elect to redeem the RPS, the holders are entitled to receive payment of the par value and any premiums on the RPS together with any dividend accrued whether declared or not. The issuing company has a past history of profitability and a dividend has always been paid. As a result, the issuing company contends that the payment of a dividend is dependent only on its willingness to pay, and the non-payment of a dividend is a materially remote possibility.

Reasons for decision
Summary: The RPS are an equity interest as defined in subsection 974-70(1) of the ITAA 1997 because: the issue of RPS is a scheme (as defined in subsection 995-1(1) of the ITAA 1997) that falls within one of the equity tests in the equity interest table contained in subsection 974-75(1) of the ITAA 1997 (an RPS gives rise to an interest as a member (shareholder) of the issuing company, Item 1 in the equity interest table); and the RPS are not characterised as, and do not from part of a larger interest that is characterised as, a debt interest (as defined in subsection 974-15(1) of the ITAA 1997) in the issuing company. 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, The RPS will not give rise to an effectively non-contingent obligation (as defined in section 974-135 of the ITAA 1997) because the issuing company does not have an obligation, either in substance or effect, to pay a dividend or redeem the RPS and pay an amount equal to the par value and any premiums on the RPS together with any dividend accrued, whether declared or not. Subsection 975-135(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) other than the ability or willingness of an entity to meet the obligation. The issuing company's ability to pay a dividend will depend on the existence of profits, because it can only pay a dividend out of profits pursuant to the operation of the Corporations Act 2001 . Accordingly, if there are no profits, the issuing company will not have an effectively non-contingent obligation to pay a dividend. The effectively non-contingent nature of an obligation is not affected if the obligation is subject only to the ability or willingness of the issuer company to meet the obligation (subsection 974-135(3) of the ITAA 1997) or if any contingency is so artificial or contrived as to suggest that the occurrence of the contingency is immaterially remote or a theoretical rather than a real possibility (subsection 974-135(6) of the ITAA 1997). However, past profitability and the past payment of dividends do not result in the conclusion that there is sufficient certainty of future profitability or certainty as to future economic performance to support a view that a dividend will become payable. Accordingly, it cannot be concluded that there is an effectively non-contingent obligation to provide the required financial benefit. In addition, the issuing company will not have an effectively non-contingent obligation to redeem the RPS and pay an amount, because redemption is at the discretion of the directors and there is no compulsion on 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 is under an obligation to redeem the RPS, if the directors of the issuing company never exercise their discretion to redeem the RPS, the RPS will never be redeemed and no payments will be owing. 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 benefit received. Only the value of those financial benefits that the issuing company has an effectively non-contingent obligation to provide are taken into account in determining whether the requirement in paragraph 974-20(1)(d) of the ITAA 1997 is satisfied.

Legislative references: Income Tax Assessment Act 1997 Subsection 974-15(1) Subsection 974-20(1) Subsection 974-70(1) Subsection 974-75(1) Section 974-135 Subsection 995-1(1)
Subject references: Debt equity borderline