ATO ID 2003/1021: Classification of certain converting preference shares under Division 974 of the ITAA 1997
Date of decision: 5 November 2003
Year of income: Year ended 30 June 2004
Business line: Finance and Investment Centre of Expertise

Issue
Is a converting preference share which is issued on terms that it will convert to ordinary shares in the issuer if the issuer is listed on the Stock Exchange, or be bought back at a premium if the issuer is not so listed, an equity interest pursuant to Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. The converting preference share is an equity interest in terms of subsection 974-70(1) of Division 974 of the ITAA 1997.

Facts
A converting preference share is issued on terms that it will convert to ordinary shares in the issuer, if the issuer is listed on the Stock Exchange; or be bought back at a premium, if the issuer is not so listed. The payment of dividends is at the discretion of the directors and the dividends are non-cumulative. The issuer has applied for its shares to be listed. Listing for this particular issuer at this time is a real possibility.

Reasons for decision
Summary: (a) The test for an equity interest The converting preference share is an equity interest in the issuer in terms of subsection 974-70(1) of the ITAA 1997, as it satisfies the equity test in subsection 974-75(1) and does not pass the debt test in subsection 974-20(1). The converting preference share is an interest in a company as a member or stockholder of that company. Therefore, Item 1 of subsection 974-75(1) of the ITAA 1997 is satisfied and the converting preference share passes the basic test for an equity interest. As a scheme cannot give rise to an equity interest if it is also classified as a debt interest (refer to paragraph 974-70(1)(b) of the ITAA 1997), it is necessary to determine, not only if the interest satisfies an item in the equity table, but also whether satisfies the test for a debt interest pursuant to subsection 974-20(1) of the ITAA 1997. (b) The test for a debt interest Subsection 974-20(1) of the ITAA 1997 provides the test for a debt interest. It lists various essential elements which must be met if a scheme is to satisfy the debt test. Those elements are that: The issue of the converting preference share is a scheme as defined in subsection 995-1(1) of the ITAA 1997. This scheme is a financing arrangement in terms of paragraph 974-130(1)(a) as it raises finance for the issuer. Therefore paragraph 974-20(1)(a) is satisfied. As the issuer receives a financial benefit, being the issue price of the converting preference share, paragraph 974-20(1)(b) of the ITAA 1997 is satisfied. As the obligation to pay dividends on the converting preference share is at the discretion of the directors and the dividend is non-cumulative, the company does not have an effectively non-contingent obligation to provide a financial benefit in the form of a dividend. If the company is listed, the converting preference share will be converted to ordinary shares upon maturity. If the company is not listed, the converting preference share will be bought back at a premium. Pursuant to paragraph 974-30(1)(a) of the ITAA 1997, a conversion of the converting preference share into ordinary shares is not a provision of a financial benefit. Buying back the converting preference share at a premium is a provision of a financial benefit within the meaning of paragraph 974-160(1)(a) of the ITAA 1997. Accordingly this question becomes whether the issuer has an effectively non-contingent obligation to buy back the converting preference share at a premium. There is an effectively non-contingent obligation to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action (subsection 974-135(1) of the ITAA 1997). An obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation (subsection 974-135(3) of the ITAA 1997). In determining whether there is in substance or effect a non-contingent obligation to take the action, one must have regard to the artificiality, or the contrived nature, of any contingency on which the obligation to take the action depends (subsection 974-135(6) ITAA 1997). The Explanatory Memorandum to the New Business Tax System (Debt and Equity) Act 2001 states: 2.178 ... In addition, consistent with the principle inherent in the debt test of focusing on economic substance rather than legal form, where a contingency is so remote as to be effectively inoperative (immaterially remote) it is as if the contingency did not exist and it should be disregarded. 2.179 In some circumstances it will be clear that a particular contingency is immaterially remote for these purposes. These will be cases where there is only a theoretical rather than a real possibility of the contingency occurring. If the issuer's shares are listed, the issuer does not have an obligation to provide a financial benefit. Provision of a financial benefit by the issuer, that is, buying back the converting preference share at a premium, is contingent on the issuer not being listed. As the listing of the issuer is a real possibility, the listing of the issuer's shares is not an immaterially remote contingency. The issuer therefore does not have an effectively non-contingent obligation to buy back the converting preference share at a premium, that is, provide a financial benefit. Thus the scheme does not satisfy the debt test. The converting preference share is therefore an equity interest in terms of subsection 974-70(1) of Division 974 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 subsection 974-20(1) paragraph 974-20(1)(a) paragraph 974-20(1)(b) paragraph 974-20(1)(c) Paragraph 974-30(1)(a) Subsection 974-70(1) subsection 974-75(1) paragraph 974-130(1)(a) subsection 974-135(1) subsection 974-135(3) subsection 974-135(6) subsection 974-160(1)
Related ATO interpretative decisions: ATO ID 2003/900
Subject references: Conversion of securities Debt test Effectively non-contingent obligation Equity test Debt equity borderline