ATO ID 2003/870: Debt/Equity Borderline: characterisation of related schemes
Date of decision: 16 September 2003
Year of income: Year ended 30 June 2002
Business line: Finance and Investment Centre of Expertise

Issue
Will the issue of loan notes and shares that are related schemes under section 974-155 of the Income Tax Assessment Act 1997 (ITAA 1997) give rise to a debt or an equity interest pursuant to the operation of Division 974 of the ITAA 1997?

Decision
The related schemes will give rise to a debt interest as they will satisfy the requirements of a debt interest as defined in subsection 974-15(1) of the ITAA 1997.

Facts
A company intends raising funds via the issue of two different types of securities, ordinary shares and loan notes. The shares and the loan notes will be issued under the one agreement. An investor subscribing to the company will be required to acquire both the shares and the loan notes. The subscription price for each loan note will be one hundred dollars ($100). The subscription price for each share will be one dollar ($1). The loan notes will be redeemed within 10 years of date of issue. Interest will be payable on the loan notes at 10% per annum compounding. The issuer has the choice of paying interest on the specified payment dates or capitalising the interest. Interest capitalised will not be payable until the loan notes are redeemed.

Reasons for decision
Summary: The constituent schemes (namely, the shares and the loan notes) give rise to a debt interest because they satisfy the criteria under which related schemes give rise to a debt interest (paragraphs 974-15(2)(a) to 974-15(2)(c) of the ITAA 1997). The constituent schemes do not satisfy all of the criteria under which related schemes give rise to an equity interest (paragraphs 974-70(2)(a) to 974-70(2)(c) of the ITAA 1997). Paragraph 974-15(2)(a) of the ITAA 1997 requires that 'the entity enters into, participates in or causes another entity to enter into or participate in the constituent schemes...' This requirement is met, because the company will require any investor who wishes to invest, to subscribe to both the loan notes and the shares. Paragraph 974-15(2)(b) of the ITAA 1997 requires that the operation of the constituent schemes (the loan notes and the shares) in combination (the 'notional scheme'), would satisfy the debt test in subsection 974-20(1) of the ITAA 1997. To satisfy the debt test, paragraphs 974-20(1)(a) to 974-20(1)(e) of the ITAA 1997 must be satisfied. These paragraphs are satisfied because: The value of the financial benefits provided and the value of the financial benefits received are both not nil (paragraph 974-20(1)(e) of the ITAA 1997). Paragraph 974-15(2)(c) of the ITAA 1997 requires that it be reasonable to conclude that the entity intended that the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of a debt interest. The constituent schemes, in combination, do have an economic effect that is equivalent to a debt interest. The issuer has in substance and effect an obligation to repay the total investment amount on the loan notes and interest whether capitalised or not. Having regard to the investment amounts attributable to the loan notes and shares, and that each individual share is to be subscribed to with a loan note, the obligations of the issuer to repay the amounts arising under the loan notes will exceed the entire investment amount. Accordingly, it would be reasonable to conclude that the company intended the combined economic effects of the constituent schemes to be similar to the economic effects of a debt interest. The constituent schemes would not satisfy the criteria necessary for the related schemes to be characterised as an equity interest (paragraphs 974-70(2)(a) to 974-70(2)(c) of the ITAA 1997). The constituent schemes would not to give rise to an equity interest as required under paragraph 974-70(2)(b) of the ITAA 1997 because those constituent schemes would not give rise to an equity interest under subsection 974-70(1) of the ITAA 1997 given that the interest would be characterised as a debt interest. In addition, it could not be said that it is reasonable to conclude that the entity intended the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest (paragraph 974-70(2)(c) of the ITAA 1997).

Legislative references: Income Tax Assessment Act 1997 subsection 974-15(1) subsection 974-15(2) subsection 974-20(1) subsection 974-20(2) subsection 974-20(3) subsection 974-20(4) subsection 974-35(1) subsection 974-70(1) subsection 974-70(2) subsection 974-130(1) subsection 974-160(1)
Subject references: Financing arrangement Debt equity borderline