Private ruling: Division 974 related schemes
Published: October 2014
Ruling period: Year ended 30 June XXXX to year ended 30 June XXXX
Date scheme commenced: Year ended 30 June XXXX

Ruling: Q1: Is any combination of the ordinary shares in the Company and any one or more of the loans made to the Company, related schemes, within the meaning of section 974-155 of the Income Tax Assessment Act 1997 Act (ITAA 1997)? | A1: Yes | Q2: If the answer to question 1 above is that the ordinary shares in the Company and any one or more of the other schemes referred to in that question is a related scheme within the meaning of section 974-155 of the ITAA 1997, would it be reasonable to conclude that the Company intended, or knew that a party to one of those schemes intended, that the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest within the meaning of paragraph 974-70(2)(c) of the ITAA 1997? | A2: No | Q3: If question 2 above is applicable and the answer to it in relation to any two or more of the schemes referred to in question 1 is yes, would the Commissioner determine under subsection 974-70(4) of the ITAA 1997 that it would be unreasonable to apply subsection 974-70(2) of the ITAA 1997 to those schemes? | A3: As the answer to question 2 is No, subsection 974-70(4) of the ITAA 1997 is not applicable.

Relevant facts and circumstances: The Company was formed to participate in the development of a project (the Project). The sponsors of the Project are Company B and Company C. A subsidiary of Company B and a subsidiary of Company C, which held shares in the Company, have entered into a Shareholders Agreement to regulate their relationship with the Company and each other and the conduct by the Company of its intended business. Some of the funding required by the Company for the development of the Project will be provided to the Company by its shareholders. Part of that shareholder funding will be provided by subscriptions for ordinary share capital and other parts of that funding will be provided by way of loans to the Company either made by the shareholders or by external lenders benefiting from the cover of one or more of the shareholders. To this end, the Company has put in place a syndicated loan facility under which it can borrow up to a specified amount (the Senior Debt) from a syndicate of commercial banks. The Senior Debt is to be secured over the Project Assets. In addition to ordinary share capital and Senior Debt, there are other senior and subordinated loan types which constitute potential sources of funding for the Project. These loans and the Senior Debt constitute the loans for the project (the loans). The other senior debt loan types rank pari passu with the Senior Debt in right of repayment. The other subordinated debt loan types are subordinated in right of repayment to the Senior Debt, the other senior debt loans. The order in which these different sources of shareholder funding can be provided to the Company is subject to agreement between the shareholders and may be varied as agreed. The loans are provided by, or benefit from the cover of, each of the shareholders in proportion to its shareholding. Each shareholder may choose how much of each type of debt (senior and subordinated) is to be lent directly by it or by a third party. Therefore, the total of each of type of loan provided by or covered by each shareholder is in proportion to the shareholding of that shareholder. After the commencement of commercial operations the subordinated debt, can only be repaid after first servicing Senior Debt as required. In addition, the financing documentation limits the sum of the Senior Debt and other senior debt to a specific percentage of the total Project funding. The financing documentation also imposes a limit on the maximum amount of Senior Debt that the Company can incur to an amount such that the projected debt service cover ratio is above a specified ratio, and the loan life cover ratio is above a specified ratio. Finally, the maximum amount of Senior Debt that the Company is allowed to raise under the loan documentation agreed with the lenders is limited to a specified amount. Assumptions • The subordinated loans impose upon the Company an effectively non-contingent obligation to repay the principal in full and require the payment of interest priced at an arm's length rate equal to the rate charged by the other commercial lenders in the project finance pool plus a subordination premium due to its subordinated nature. • If the subordinated loans are not characterised under Division 974 as part of two or more related schemes, they satisfy the requirements of section 974-20 of the ITAA 1997 to be characterised as debt interests. • The ordinary shares in the Company, if not part of two or more related schemes, are characterised as equity interests under Division 974 of the ITAA 1997.

Relevant legislative provisions: Income Tax Assessment Act 1997 Division 974 | Income Tax Assessment Act 1997 subsection 974-70(2) | Income Tax Assessment Act 1997 paragraph 974-70(2)(b) | Income Tax Assessment Act 1997 paragraph 974-70(2)(c) | Income Tax Assessment Act 1997 subsection 974-70(3) | Income Tax Assessment Act 1997 subsection 974-70(4) | Income Tax Assessment Act 1997 subsection 974-70(5) | Income Tax Assessment Act 1997 subsection 974-75(1) | Income Tax Assessment Act 1997 section 974-155 | Income Tax Assessment Act 1997 subsection 974-155(2) | Income Tax Assessment Act 1997 paragraph 974-155(2)(a) | Income Tax Assessment Act 1997 paragraph 974-155(2)(b) | Income Tax Assessment Act 1997 paragraph 974-155(2)(d) | Income Tax Assessment Act 1997 paragraph 974-155(2)(e) | Income Tax Assessment Act 1997 subsection 974-155(3)

Reasons for decision: Summary: Section 974-155 of the ITAA 1997 sets out the circumstances in which two or more schemes are to be treated as related schemes for the purposes of Division 974 of the ITAA 1997. | Detailed Reasoning - Scheme: Scheme is defined in subsection 995-1(1) of the ITAA 1997 to mean any arrangement or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. The definition of scheme is broad and would include the various finance raising methods undertaken by the Company through the issue of ordinary shares and the relevant loans. That is, the issue and allotment of ordinary shares in the Company, the provision of Senior Debt, the provision of senior loans and provision of subordinated loans would each constitute a scheme as defined in subsection 995-1 of the ITAA 1997. | Detailed Reasoning - Related schemes: Subsection 995-1(1) of the ITAA 1997 provides that "related scheme" has the meaning given by section 974-155 of the ITAA 1997 which sets out the circumstances in which two or more schemes are related to one another for the purposes of Division 974. Section 974-155(1) of the ITAA 1997 provides: Subject to subsection (3), 2 *schemes are related to one another if they are related to one another in any way. Subsection 974-155(2) of the ITAA 1997 states that, without limiting subsection 974-155(1) of the ITAA 1997, two schemes are related to each other if: • The schemes are based on stapled instruments • One of the schemes would, from a commercial point of view, be unlikely to be entered into unless the other scheme was entered into • One of the schemes depends for its effect on the operation of the other scheme • One scheme complements or supplements the other • There is another scheme to which both the schemes are related because of a previous application or applications of subsection 974-155(2) of the ITAA 1997 Subsection 974-155(3) of the ITAA 1997 provides that two schemes are not related to one another merely because one refers to the other or where the schemes have a common party. Whether the test as set out under subsection 974-155(1) of the ITAA 1997 would apply would involve a cumulative consideration of all the factual circumstances and documentation provided to determine if two schemes are related to one another in any way. The ordinary shares in the Company and each of the loans provide a discrete element of the funding expected to be required for the Project. In that sense, each of these schemes is entered into in pursuit of the same ultimate purpose. The main purposes of the Company's funding policy are to confirm the source of funds for the Project, the amount of each funding source, the order in which each funding source will be drawn or repaid, and the procedures to be followed to meet the lenders' requirements for drawdowns. Funding source refers to, among other things, share capital in the Company and the loans. The funding policy includes the following requirements and ratios in relation to the Project: • The maximum amounts of share capital relative to loans. • Restrictions on additional equity and relationship of additional equity and drawdowns of loan commitments under the Project. • The Project's debt to equity ratio cap. • Various other debt to equity ratios. • Detailed clauses relating to funding sources, funding plans and funding methods, order of incurrence of funding sources, incurring of additional debt, prepayment and repayment of subordinated loans, and prepayment of senior debt. The financing documentation limits the amounts of senior debt to a percentage of total Project funding. The financing documentation also imposes a limit on the maximum amount of senior debt and the loan cover ratio. The Shareholders Agreement deals with the funding of the Company in relation to the Project. The documentation refers to the funding policy and states that the funding policy addresses funding options for the Company including policy and principles applicable to raising, borrowing or incurring senior debt and shareholder contributions. The Company must be funded in accordance with a funding policy as agreed upon by the shareholders and if a funding method has not been agreed upon, then shareholder contributions will be funded by way of shareholder debt. The Shareholders Agreement states that shareholders shall satisfy their shareholder contributions in the same proportions that their shareholdings represent in the capital of the Company. For example, if 20% of shareholder contributions are to be satisfied by way of share capital, 40% by subordinated debt and 40% by senior debt then all shareholders must ensure their shareholder contributions match this form and are contributed in proportion to their respective shareholding percentages. Under the Shareholders Agreement, shareholders must ensure that the portion of the senior debt they make available or otherwise procure is equal to the proportion that their shareholdings represent in the capital of the Company expressed as a percentage unless otherwise agreed by the shareholders. Accordingly, there is interacting operation regarding the ordinary shares in the Company and the loans under the funding policy and the Shareholders Agreement. The debt and equity funding options are also subject to financial ratio covenants applicable under the terms of the debt facilities (and otherwise subject to the indicative limits set out under the approved funding policy). The repayment clauses under the loan documentation are similar, as are the terms of debt with the senior loan terms. Overall, based on a cumulative consideration of all the factual circumstances and documentation provided, there is a sufficient connection between the ordinary shares and any combination of the loans of the Project so that the ordinary shares and any combination of the loans are related schemes within the meaning of subsection 974-155(1) of the ITAA 1997. Subsection 974-155(1) provides (subject to subsection 974-155(3) of the ITAA 1997) that two schemes are related to one another if they are related to one another in any way and is drafted broadly. In addition, the contribution of the loans follows as a result of the existence of the ordinary shareholdings. Pursuant to paragraph 974-155(2)(b) of the ITAA 1997, it is commercially unlikely that the loans would be entered into by the shareholders if they did not hold ordinary shares in the Company. There is a sufficient connection between the ordinary shareholdings and the contribution of the loans for the purposes of satisfying subsection 974-155(1) of the ITAA 1997. Furthermore, the loans and ordinary shares 'complement or supplement each other' so as to be within the inclusive example of paragraph 974-155(2)(d) of the ITAA 1997. 'Complement' and 'supplement' are not defined terms for the purposes of the Income Tax Assessment Act 1936 and the ITAA 1997 and therefore take their ordinary meanings. The Macquarie Dictionary defines supplement to mean: 1. something added to complete a thing, supply a deficiency, or reinforce or extend a whole. 2. a part added to a book, document, or the like to supply deficiencies or correct errors… Funds may be raised by the Company by way of the issue of shares or alternatively by raising debt through the loan agreements. The shareholdings and any combination of the loans reinforce or supply a deficiency in each other and added together complete and satisfy the Company's overall funding requirements of the Project. Therefore, the issue of ordinary shares in the Company and loans provided to the Company supplement each other to be within paragraph 974-155(2)(d) of the ITAA 1997. | Detailed Reasoning - Conclusion: The shareholdings and any combination of the loans are related schemes within the meaning of section 974-155 of the ITAA 1997. | Detailed Reasoning - Question 2: The shareholdings and the relevant loans constitute separate schemes for the purposes of Division 974 of the ITAA 1997. However, a combination of the shareholding and any of the loans are also related schemes pursuant to section 974-155 of the ITAA 1997. Under subsection 974-70(2) of the ITAA 1997 two or more related schemes (the constituent schemes) are taken together to give rise to an equity interest in a company if: (a) the company enters into, participates in or causes another entity to enter into or participate in the constituent schemes; and (b) a scheme with the combined effect or operation of the constituent schemes (the notional scheme) would give rise to an equity interest in the company under subsection 974-70(1) of the ITAA 1997 if the notional scheme came into existence when the last of the constituent schemes came into existence; and (c) it is reasonable to conclude that the company intended, or knew that a party to the scheme intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest. On the facts, the Company will have entered into, participated or caused another entity to enter into or participate in the constituent schemes for the purposes of paragraph 974-70(2)(a) of the ITAA 1997. Furthermore, one of the constituent schemes which is related to one or more of the other schemes, namely the actual shares in the Company, would itself be an equity interest under subsection 974-70(1) of the ITAA 1997. On this basis, any related scheme which includes that scheme as a constituent scheme would necessarily have, at least to that extent, economic effects similar to an equity interest for the purposes of paragraph 974-70(2)(b) of the ITAA 1997. However, based on a consideration of all the factual circumstances, it is not reasonable to conclude that the Company intended, or knew that a party to the scheme intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest under paragraph 974-70(2)(c) of the ITAA 1997. The Senior Debt is provided by third parties unrelated to the shareholders in the Company under the initial syndicated facility agreement. The Senior Debt and the senior loans have equal ranking in security and priority to other creditors of the Company. The subordinated loans retain priority in right of repayment over the ordinary shares. They also include an effectively non-contingent obligation to repay the principal in full and the sole return on them is an interest coupon which is typical of debt. The subordinated loans are also not required to be provided by the shareholders themselves. Instead it may be provided by their respective affiliates or by independent third party banks or other financial institutions. The factual circumstances do not give rise to any sufficiently compelling reason or feature in order to arrive at the conclusion that is required for paragraph 974-70(2)(c) of the ITAA 1997 to apply. The objective intention of the constituent schemes is supportive of a debt-equity funding mix for the Project rather than an objective intention that the combined economic effects be the same or similar to the economic effects of an equity interest. Paragraph 974-70(2)(c) of the ITAA 1997 is not satisfied. | Detailed Reasoning - Question 3: The answer to question 2 is No. Therefore, subsection 974-70(4) of the ITAA 1997 is not applicable.