ATO ID 2009/152: Benchmark rate of return: Mandatorily Redeemable Preference Share (MRPS)
Date of decision: 24 September 2009
Year of income: Year ending 31 December 2010
Business line: Public Groups and International

Issue
When determining the benchmark rate of return for a test interest under subsection 974-145(2) of the Income Tax Assessment Act 1997 (ITAA 1997), can that benchmark rate be adjusted to take into account differences between the test interest and the benchmark interest other than those relating to the characteristics listed in paragraphs 974-145(1)(a) to 974-145(1)(f) of the ITAA 1997?

Decision
No. The benchmark rate of return for a test interest cannot be adjusted to take into account differences other than those relating to the characteristics listed in paragraphs 974-145(1)(a) to 974-145(1)(f) of the ITAA 1997.

Facts
A company issued mandatorily redeemable preference shares (MRPS). The MRPS are mandatorily redeemable for their issue price nine years from their date of issue and are characterised as debt interests for the purposes of Division 974 of the ITAA 1997. The MPRS give their holders only a contingent right to dividends as any dividends are conditional upon the availability of distributable profits of the Company and upon the board exercising its discretion to pay a dividend. The funds raised by the issue of the MRPS are used by the Company for the purposes of gaining or producing its assessable income. Due to the operation of sections 8-1 and 25-85 of the ITAA 1997, the Company is entitled to an income tax deduction for the return paid on the MPRS to the extent that the annually compounded internal rate of return does not exceed the benchmark rate of return for the interest increased by 150 basis points. The Company, in determining the benchmark rate of return, could find no ordinary debt interest which satisfied the criteria of subsection 974-145(1) of the ITAA 1997 that is there was no ordinary debt interest issued by the Company or an equivalent entity immediately before the test interest issued which: had a comparable maturity date; was issued in the same market and currency; had the same credit status; and had the same degree of subordination to debts owed to the ordinary creditors of the Company. The Company thus determined the benchmark rate of return by reliance on subsection 974-145(2) of the ITAA 1997.

Reasons for decision
Summary: Subsection 995-1(1) defines "benchmark rate of return" for an interest as having the meaning given by section 974-145 of the ITAA 1997. The benchmark rate of return for an interest is determined in the first instance under subsection 974-145(1) of the ITAA 1997, by comparing the test interest with an "ordinary debt interest" that bears the same specified characteristics as the test interest. An "ordinary debt interest" is defined in subsection 995-1(1) of the ITAA 1997 as having the meaning given by section 974-140 of the ITAA 1997. If an 'ordinary debt interest' with the requisite characteristics is found, the benchmark rate of return equals the annually compounded internal rate of return on that ordinary debt interest. No adjustments are made to the benchmark rate of return so determined to accommodate any differences between the ordinary debt interest and the test interest (including, of course, differences based on the discretionary dividend characteristics of the test interest under consideration here). If no ordinary debt interest with the specified characteristics can be found, subsection 974-145(2) of the ITAA 1997 instructs that an ordinary debt interest which is the next closest interest to the test interest in respect to those characteristics be found. This subsection then allows appropriate adjustments to the benchmark rate of return to take account of the differences between that next closest interest and the test interest. It is logical to make such adjustments for differences relating to the factors listed in subsection 974-145(1) of the ITAA 1997 because those are the differences which necessitated the move from the best benchmark interest under subsection 974-145(1)(1) to the next best in subsection 974-145(1)(2). There is however no reason to make adjustments for other, new differences (such as the discretionary dividend characteristics of the test interest), which cannot be taken into account in the case where the best or closest ordinary debt interest can be found under subsection 974-145(1) of the ITAA 1997. It is thus considered that the structure of section 974-145 of the ITAA 1997 and a logical reading of that provision clarifies that the "differences" referred to in subsection 974-145(2) of the ITAA 1997 are limited to those relating to the factors listed in subsection 974-145(1) of the ITAA 1997. Support for this interpretation can be found in the operation and clear policy intent of the statutory provisions employing the concept of the benchmark rate of return. For example, section 25-85 of the ITAA 1997 uses the concept to limit deductions for dividends or other contingent returns on interests that satisfy the debt test. Paragraphs 2.138 and 2.139 of the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Act 2001 describe the provision as a revenue safeguard that limits deductible payments on debt/equity hybrids where returns are "considerably in excess of the interest payable on an equivalent interest without any equity component (i.e. straight debt)". Accordingly, deductions are capped by reference to a benchmark rate of return " on an equivalent straight debt interest , increased by a margin [150 basis points] to recognise the premium paid for the increased risk of non-payment because of the contingency" [emphasis added]. It would defeat the clear policy intent of this provision to allow a benchmark interest to have an equity component. This would be the outcome if a broad interpretation of "differences" in subsection 974-145(2) of the ITAA 1997 allowed adjustments to the benchmark rate of return to reflect the equity characteristics of the test interest. Furthermore, such an interpretation would undermine the intentionally limited accommodation of the equity component of the test interest through the 150 basis point margin. Accordingly, in determining the benchmark rate of return for the MPRS, the annually compounded internal rate of return on an interest that is closest to the MPRS, cannot be adjusted to take into account differences between that interest and the MPRS apart from differences based on factors listed in subsection 974-145(1) of the ITAA 1997. This includes not allowing an adjustment to take into account the discretionary nature of any dividend entitlement on the MPRS.

Legislative references: Income Tax Assessment Act 1997 section 8-1 section 25-85 section 974-140 section 974-145 subsection 974-145(1) subsection 974-145(2) subsection 995-1(1)
Subject references: Debt equity borderline Non-equity share