ATO ID 2002/1113: Convertible Notes - Non-Share Distribution as a Frankable Non-Share Dividend
Date of decision: 18 March 2002
Year of income: Other/Substituted Accounting Period 2004
Business line: Office of the Chief Tax Counsel

Issue
Where a scheme of arrangement alters the character of a convertible note from a debt interest to a non-share equity interest, will subsequent non-share distributions made by a non-bank issuer be treated as frankable non-share dividends under section 160APA of the Income Tax Assessment Act 1936 (ITAA 1936)?

Decision
Yes. A non-share distribution paid by a non-bank issuer on the convertible note will be a frankable dividend as defined in section 160APA of the ITAA 1936 where: (i) the distribution is paid in respect of the convertible note when it is a non-share equity interest is a non-share dividend and not a distribution of non-share capital; and (ii) the non-share dividend is not a non-share dividend to which subsection 160APA(gb) of the ITAA 1936 applies.

Facts
Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) applies to convertible notes issued by a non-bank issuer. The convertible notes are a debt interest pursuant to Division 974 of the ITAA 1997. The non-bank issuer is proposing to enter into a scheme of arrangement in respect of those convertible notes which will have the effect of ensuring that the holders of the convertible notes at their maturity convert their notes into shares of the issuer. The terms of the scheme of arrangement provide that the note holders will continue to receive interest payments on the non-share equity interests until maturity.

Reasons for decision
Summary: A frankable dividend is defined in section 160APA of the ITAA 1936 to include...'(a) a dividend within the meaning of section 6; or...(aaa) a non-share dividend.....but does not include ......(gb) a non-share dividend that is taken by section 160APAAAB not to be a frankable dividend '. A non-share dividend for the purposes of the ITAA 1997 takes its definition from subsection 995-1(1) of the ITAA 1997. This definition provides that a non-share dividend has the meaning given by section 974-120 of the ITAA 1997. Section 974-120 of the ITAA 1997 provides that all non-share distributions are non-share dividends to the extent to which those distributions do not represent a return of non-share capital or share capital. In turn, section 974-115 of the ITAA 1997 provides that a non-share distribution arises where you hold a non-share equity interest in a company and the company, as a result of you being a non-share equity interest holder, distributes money to you, distributes other property to you or credits an amount to you. In the present case, the distributions on the non-share equity interest would give rise to a non-share distribution because the distributions would be paid as a result of the note holder being a holder of a non-share equity interest. Those non-share distributions - the regular interest payments on the convertible note - would not represent distributions of non-share capital or share capital. Accordingly, the distributions paid on the non-share equity interest [the convertible note] would be non-share dividends as defined pursuant to the operation of sections 974-115 and 974-120 of the ITAA 1997. Section 160APA of the ITAA 1936 would, by virtue of the definition contained in subsection 160APA(aa) of the ITAA 1936, treat the non-share dividends as a frankable dividend, subject to section 160APAAAB not applying to treat the non-share dividend as a non-frankable non-share dividend. Section 160APAAAB of the ITAA 1936 will apply to treat a non-share dividend as a non-frankable non-share dividend where the 'available frankable profits' requirements set out in that section are not satisfied.

Legislative references: Income Tax Assessment Act 1997 section 974 -115 section 974-120 subsection 995-1(1)
Other references: Explanatory Memorandum: New Business Tax System (Debt and Equity) Act 2001
Subject references: Convertible notes Debt equity borderline