Private ruling: Debt and equity rules – related schemes
Date of advice: 27 March 2019
Published: May 2019
Ruling period: Income year ended 30 June 2017 to | Income year ending 30 June 2027
Date scheme commenced: 2017

Ruling: Q1: Are the Series A Preference Shares related to the Loan Notes such that they would be regarded as related schemes? | A1: Yes | Q2: If the Series A Preference Shares and Loan Notes are related schemes for the purposes of section 974-155 of the ITAA 1997, do the constituent schemes (being the Series A Preference Shares and Loan Notes) together give rise to a debt interest in A Pty Ltd pursuant to section 974-15(2) of the ITAA 1997? | A2: No | Q3: If the Commissioner considers that the Series A Preference Shares and the Loan Notes are related schemes that together give rise to a debt interest in A Pty Ltd pursuant to section 974-15(2) of the ITAA 1997, will the Commissioner make a determination pursuant to subsection 974-112(3) as provided for in subsection 974-15(4), that it would be unreasonable to treat the schemes as giving rise to a debt interest under Section 974-15(2)? | A3: Not applicable, as the Commissioner has ruled the constituent schemes (being the Series A Preference Shares and Loan Notes) together do not give rise to a debt interest in A Pty Ltd pursuant to section 974-15(2) of the ITAA 1997. | Q4: If the Series A Preference Shares and Loan Notes are related schemes for the purposes of section 974-155 of the ITAA 1997, do the constituent schemes (being the Series A Preference Shares and Loan Notes) together give rise to an equity interest in A Pty Ltd pursuant to section 974-70(2) of the ITAA 1997? | A4: No

Relevant facts and circumstances: Background The D group of entities (the D Group) carries on a wholesaling business. In 2017, the “X Trusts” and Y existing D Group stakeholders (the founders) indirectly acquired the D Group. The X Trusts consist of: ● Trust 1; ● Trust 2; ● Trust 3; and ● Trust 4. The D Group’s purchasers established A Pty Ltd to facilitate the purchase of the D Group. A Pty Ltd’s capital structure In order to purchase the D Group, A Pty Ltd raised approximately $X by issuing: ● Ordinary Shares, Series Z Ordinary Shares, Series A Preference Shares, and Loan Notes to the X Trusts; and ● Ordinary Shares and Series Z Ordinary Shares to the founders. The terms of the Ordinary Shares, Series Z Ordinary Shares, Series A Preference Shares, Series B Preference Shares, and Loan Notes are set out in various documents, including the Constitution and Loan Notes Deed Poll. The Ordinary Shares are ordinary shares in the capital of A Pty Ltd. The declaration of any dividends on the Ordinary Shares is at the discretion of the Board. Further, the holders of Ordinary Shares are not entitled to repayment of the issue price of the shares. The Series Z Ordinary Shares have no voting rights other than where the vote relates to changing the rights to the Series Z Ordinary Shares themselves. The Series Z Ordinary Shares have a priority to any dividend payment by A Pty Ltd. However, the entitlement to receive any dividends is determined by the board of directors, acting prudently, and subject to certain 'earnings before interest and tax' targets being achieved. On a wind up of, or a return of capital by A Pty Ltd, the rights of each holder of Series Z Shares to a return of paid up capital rank behind the prior rights of all other shares. The rights attaching to the Series A Preference Shares are summarised as follows: ● They rank ahead of Ordinary Shares, Series M preference Shares, Series M Ordinary Shares, Series B Preference Shares and equally with Series Z Ordinary Shares in respect of the payment of dividends. ● Accrued dividends are payable at the discretion of the Board. ● They are redeemable by the issuer in the event of certain Exit Events and Defaults and voluntarily by the issuer. ● They carry an entitlement to be repaid an amount in excess of the issue value on a redemption or certain other events. ● They do not have voting rights other than where the matter relates to changing the rights of the Series A Preference Shares. The terms of the Loan Notes are summarised as follows: ● They pay interest which accrues on a compounding basis at a rate of 8.8% per annum, which is calculated on an actual days elapsed basis and is payable quarterly with 90% of the interest amount capitalised and added to the face value on each interest payment date; and ● The Loan Notes are mandatorily redeemable on the Maturity Date (being nine years and eleven months after the date of issue) or the occurrence of an Exit Event. The issuer can also choose to voluntarily redeem the Loan Notes. ● An Exit Event is defined in the relevant documentation to mean: ● An initial public offering; ● A sale by the X Trusts of a majority of the securities held to a party that is not an affiliate; or ● A sale to a third party of, at least, substantially all of the operating entities of the business (a trade sale). A Pty Ltd has also issued Series B Preference Shares and Series M Preference Shares to management. These were issued after the acquisition of the D Group. Stapling ● The Series A Preferences Shares and the Loan Notes are stapled with the following features: ● They must be held by the X Trusts in equal proportions – that is, on a one-for-one basis, on completion; ● The X Trusts must not transfer their holdings in the Series A Preference shares without transferring an equal amount of their holdings in the Loan Notes (and vice versa); ● The prescribed proportion must be maintained where A Pty Ltd allots, issues, redeems, buys back, cancels, repays or otherwise deals with the Series A Preference Shares or the Loan Notes; and A Pty Ltd and each security holder must do all things necessary to maintain the proportional shareholding of Series A Preference Shares and Loan Notes while the X Trusts funds are holders.

Relevant legislative provisions: Sections 974-15, 974-70, 974-112 and 974-155 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: Summary The Series A Preference Shares and the Loan Notes are related schemes as defined by section 974-155 of the Income Tax Assessment Act 1997 (ITAA 1997). Detailed reasoning Section 974-155 provides that two or more schemes will be related schemes if the individual schemes are related to each other in any way, including by way of stapling. The Series A Preference Shares and the Loan Notes are stapled to each other in the sense that they are governed by proportional holding rules with the effect that the X Trusts cannot transfer their holdings in the Series A Preference Shares without transferring an equal number of their holdings in the Loan Notes and vice versa. Therefore the Series A Preference Shares and the Loan Notes are related schemes and it is not necessary to consider the other grounds in section 974-155 that deal with relatedness. Summary The Series A Preference Shares and the Loan Notes do not together give rise to a debt interest in A Pty Ltd as defined by subsection 974-15(2). Detailed reasoning Related schemes give rise to a single debt interest if: (a) an entity 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 would satisfy the debt test; and (c) it is reasonable to conclude that the entity intended, or knew that a party to the scheme or one of the schemes intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of a debt interest. The issue here is paragraph (c). There is nothing in the facts as presented to indicate that any of the parties in entering into the related schemes intended for the Series A Preference Shares and Loan Notes to be aggregated and treated as having a combined economic effect. The only intention that the facts reveal is that the parties attempted to create different types of financial interests, each with the purpose of providing investors with different reasons to invest. The Series A Preference Shares provide returns that are contingent on A Pty Ltd’s economic performance and at the Board’s discretion, whereas the Loan Notes provide a guaranteed return. These related interests – along with the other interests in A Pty Ltd – are reflective of commercial negotiations between all parties to the transaction, not an intention on anyone’s part to ensure that these related instruments operate as a single debt interest for tax purposes. Summary It is not necessary for the Commissioner to make a determination under subsection 974-15(4) that it is unreasonable to treat the Series A Preference Shares and Loan Notes related schemes as debt because they do not give rise to a constituent debt scheme (paragraph 974-15(2)(c)). Detailed reasoning A taxpayer can apply under subsection 974-112 to the Commissioner for a determination under subsection 974-15(4) to the effect that related schemes will not be treated as a constituent scheme that together give rise to a debt interest. Your application under this section is conditional upon subsection 974-15(2) applying to treat the Series A Preference Shares and Loan Notes as a single debt interest. In this case, subsection 974-15(2) does not have the effect of treating the Series A Preference Shares and Loan Notes as a single debt interest and so it is not necessary for the Commissioner of Taxation to make a determination to treat them as separate interests. Summary The Series A Preference Shares and the Loan Notes do not together give rise to an equity interest in A Pty Ltd as defined by subsection 974-70. Detailed reasoning Related schemes give rise to a single equity interest if: (a) an entity 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 would satisfy the equity test; and (c) it is reasonable to conclude that the entity intended, or knew that a party to the scheme or one of the schemes intended, the combined economic effects of the constituent schemes to be the same as, or similar to, the economic effects of an equity interest. The issue here is paragraph (c). There is nothing in the facts as presented to indicate that any of the parties in entering into the related schemes intended for the Series A Preference Shares and Loan Notes to be aggregated and treated as having a combined economic effect. The only intention that the facts reveal is that the parties attempted to create different types of financial interests, each with the purpose of providing investors with different reasons to invest. The Series A Preference Shares provide returns that are contingent on A Pty Ltd’s economic performance and at the Board’s discretion, whereas the Loan Notes provide a guaranteed return. These related interests – along with the other interests in A Pty Ltd – are reflective of commercial negotiations between all parties to the transaction, not an intention on anyone’s part to ensure that these related instruments operate as a single equity interest for tax purposes.