ATO ID 2009/136: Convertible Debentures and Tainted Share Capital Accounts
Date of decision: 6 November 2009
Year of income: Year ended 30 June 2007
Business line: Public Groups and International

Issue
Will the conversion of convertible debentures held by a Head company of a tax consolidated group in its subsidiary members into ordinary shares constitute a transfer to the share capital accounts of those subsidiary members for the purposes of section 197-5 of the Income Tax Assessment Act 1997 (ITAA 1997)

Decision
No. The conversion of convertible debentures will not constitute a transfer to the share capital account of either subsidiary member for the purposes of section 197-5 of the ITAA 1997.

Facts
Company A is the Head company of a tax consolidated group with wholly owned subsidiary members being Company B and Company C. All companies are Australian resident companies. Company A (the debenture holder) holds convertible debentures which were issued by Company B and Company C (the issuers) before the formation of the tax consolidated group. For accounting purposes, the convertible debentures are classified as equity. The terms and conditions require the issuer to first redeem the debentures. The redemption proceeds are then applied as the consideration for the issue price of the ordinary shares to be held by the former debenture holder. The following journal entries will record the redemption of the debentures and conversion by the issue of ordinary shares in the financial accounts of each of the issuers:

Reasons for decision
Summary: Division 197 of Part 3-5 of the ITAA 1997 was inserted by the Tax Laws Amendment (2006 Measures No.3) Bill 2006; New Business Tax System (Untainting Tax) Bill 2006 (TLA No.3). The Explanatory Memorandum to the Bills (the 2006 EM) stated in Chapter 4 that Schedule 4 of the Bill amended the ITAA 1997 to ensure that a company's share capital account will become tainted if it transfers certain amounts to that account. The share capital tainting provisions are integrity rules designed to prevent a company from disguising a distribution of profits as a tax-preferred capital distribution by transferring profits into its share capital account and subsequently making distributions from that account. The 2006 EM also states at paragraph 4 5 that a company's share capital account will become tainted if it transfers an amount to its share capital account from any other account. | Detailed Reasoning - What constitutes a transfer of an amount to the share capital account?: Section 197-5 of the ITAA 1997 provides as follows: The expression 'transferred amount' is not defined within Division 197 or section 995-1 of the ITAA 1997 and reference must therefore be made to its ordinary meaning in the first instance. The Macquarie Dictionary does not define the meaning of the compound expression 'transferred amount'. However, the Macquarie Dictionary does define 'transfer' as: and 'amount' as: While not determinative, these definitions suggest a 'transferred amount' in the context of section 197-5 of the ITAA 1997 may mean in its broadest sense the record of the movement of any quantity of money to a company's share capital from any other of the company's accounts. However, the meaning of the expression 'transferred amount' is also discussed in the 2006 EM which explains the policy and operation of Division 197 within the ITAA 1997. The 2006 EM states the following and provides an example at paragraph 4 12 to 4 13: When is an amount transferred from one account to another account? 4.12 An amount is transferred from one account to another where that amount is moved from one account to another. This, in turn, requires the balance of the first account to be reduced, while the balance of the second account is increased by the same amount. 4.13 An amount is not transferred from one account to another where the particular accounting entries result in the balances of both accounts increasing in size. Accordingly, an accounting entry of the form 'debit asset, credit share capital account' does not represent a transfer in the relevant sense . Furthermore, a transfer to the share capital account will not arise if an expense account is debited at the same time that the share capital account is credited ( emphasis added ). Example 4.1 A company has a retained profits reserve balance of $1,000 at the beginning of the 2006-07 income year. The company issues $100 in shares on 1 September 2006 to an individual as consideration for services rendered. The share issue is accounted for by debiting the expense account by $100 and crediting the share capital account by $100. The company does not derive any income nor does it incur any other expenses during the income year. At the end of the income year, the balance of the expense account ($100 debit) will be transferred to the profit and loss account. On closure of its profit and loss account a $100 debit will be made to the company's retained profits reserve. The company's retained profits reserve is reduced by the net loss ($100) incurred over the income year, not directly by the expense itself. Therefore, no amount has been transferred from the company's retained profits reserve to its share capital account. The accounting journal entry that will credit the increase of the share capital account upon conversion of the convertible debentures by the issue of ordinary shares will be associated with an increase in a receivable (asset) account. This accounting journal entry will result in the balance of both accounts increasing in size. Within the context of paragraphs 4 11 to 4 13 of the 2006 EM, this accounting journal entry by the subsidiary members will not be a transfer in the relevant sense as it will result in both accounts increasing in size. Accordingly, the redemption and conversion of the convertible debentures to ordinary shares will not constitute a transfer of an amount in the relevant sense to the share capital account for the purposes of section 197-5 of the ITAA 1997. As such, the redemption and conversion of the convertible debentures will not cause the share capital accounts of the subsidiary members to become tainted for the purposes of Division 197 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 197-5 section 995-1
Other references: Explanatory Memorandum to Tax Laws Amendment (2006 Measures No.3) Bill 2006; New Business Tax System (Untainting Tax) Bill 2006
Subject references: Debentures Tainted share capital account