Private ruling: Application of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)
Date of advice: 17 April 2020
Published: June 2020
Ruling period: XX to XX
Date scheme commenced: XX

Ruling: Q1: Will the X Class Shares issued by X Co be treated as 'debt interests' as the term is defined under subsection 995-1(1) of the ITAA 1997? | A1: No.

Relevant facts and circumstances: X Co has on issue a number of classes of shares. X Co issues X Class Shares, being redeemable preference shares, to new senior employees of YCo. X Co holds all the ordinary shares in Y Co. X Class Shares carry the right to redemption of the subscription price and the right to participate in the surplus assets of the company. The proceeds of X Class Shares are used as working capital of X Co. The X Class Shares are redeemable on cessation of employment of the senior employee. The terms and conditions of the X Class Shares provide, among other things, that the Board of X Co may declare dividends on X Class Shares in its absolute discretion from time to time and any dividends so declared will be paid out of profits (if any).


Reasons for decision: Summary: 1. All legislative references in these 'Reasons for decision' are to the ITAA 1997 unless otherwise specified. 2. Subsection 974-15(1) provides: A *scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) in relation to the entity. *Denotes a term defined in subsection 995-1(1). 3. A debt interest will arise where the following conditions are satisfied under subsection 974-20(1): (a) the scheme is a *financing arrangement for the entity; and (b) the entity, or a *connected entity of the entity, receives, or will receive, a *financial benefit or benefits under the scheme; and (c) the entity has, or the entity and a connected entity of the entity each has, an *effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when: (i) the financial benefit referred to in paragraph (b) is received if there is only one; or (ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and (d) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and (e) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil. The scheme does not need to satisfy paragraph (a) if the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) (interest as a member or stockholder of the company). *Denotes a term defined in subsection 995-1(1). | Detailed Reasoning - Paragraph 974-20(1)(a): 4. Subsection 974-20-(1) provides that where the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) the scheme does not need to satisfy paragraph 974-20(1)(a). Item 1 of the table in subsection 974-75(1) states: An interest in the company as a member or stockholder of the company. 5. The X Class shareholders have membership interests in X Co by virtue of their shareholding in X Co. Therefore, the scheme entered into for the issue of the X Class Shares does not need to satisfy paragraph 974-20(1)(a). | Detailed Reasoning - Paragraph 974-20(1)(b): 6. A 'financial benefit' is defined in section 974-160 and includes anything of economic value. In respect of the X Class Shares, shareholders will pay the subscription price of the X Class Shares which X Co will receive on the issue of the X Class Shares. Therefore, X Co receives a financial benefit under the scheme. | Detailed Reasoning - Paragraph 974-20(1)(c): 7. An effectively non-contingent obligation (ENCO) has the meaning given in section 974-135 being: (1) 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 (see subsections (3), (4) and (6)) to take that action. (2) Without limiting subsection (1), that subsection applies to: (a) providing a *financial benefit under the *scheme; or (b) terminating the scheme. (3) 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. (4) The existence of the right of the holder of an *interest that will or may convert into an *equity interest in a company to convert the interest does not of itself make the issuer's obligation to repay the investment not non-contingent. (5) An obligation to redeem a preference share is not contingent merely because there is a legislative requirement for the redemption amount to be met out of profits or a fresh issue of *equity interests. (6) In determining whether there is in substance or effect a non-contingent obligation to take the action, have regard to the artificiality, or the contrived nature, of any contingency on which the obligation to take the action depends. Note: The artificiality, or the contrived nature, of a contingency would tend to indicate that there is, in substance or effect, a non-contingent obligation to take that action. (7) An obligation of yours is not effectively non-contingent merely because you will suffer some detrimental practical or commercial consequences if you do not fulfil the obligation. Note: For example, a contingent obligation to make payments in respect of an income security issued by an approved deposit-taking institution (ADI) is not effectively non-contingent merely because of the detrimental effect non-payment would have on the ADI's business. (8) The regulations may make further provisions relating to the following: (a) what constitutes a non-contingent obligation; (b) what does not constitute a non-contingent obligation; (c) what constitutes an *effectively non-contingent obligation; (d) what does not constitute an effectively non-contingent obligation. *Denotes a term defined in subsection 995-1(1). 8. To satisfy paragraph 974-20(1)(c) X Co must have an ENCO to provide a financial benefit after it receives the subscription price of the X Class hares. 9. One of the financial benefits of the X Class Shares are dividends, which are paid out of profits if any as the Board in its absolute discretion declares in relation to the shares from time to time in accordance with the Terms and Conditions of the X Class Shares. The payment of dividends on the X Class Shares is contingent on the Board of X Co declaring a dividend. Therefore, X Co does not have an ENCO to pay dividends on the X Class Shares. 10. The remaining financial benefit that is available under the X Class Shares is repayment of the subscription price to the holder of the X Class Shares on redemption. 11. Redemption of the X Class Shares occurs when a senior employee ceases employment. 12. In accordance with subsection 974-15(1) a debt interest only arises if the provisions of subsection 974-20(1) are satisfied when the scheme comes into existence. When the X Class Shares are issued, that is when the scheme comes into existence, there is no fixed date by which X Co must repay the subscription price as it is contingent on the holder ceasing employment, which is unknown at the date of issue. Therefore, X Co does not have an ENCO to repay the subscription price of the X Class Shares at the time of issue. 13. Since the X Class Shares do not satisfy paragraph 974-20(1)(c) it is unnecessary to determine whether the remaining conditions in subsection 974-20(1) are satisfied in relation to the scheme. 14. In view of the above, the X Class Shares do not satisfy the debt test in subsection 974-20(1) and are not 'debt interests' as the term is defined in subsection 995-1(1).

Relevant legislative provision: Income Tax Assessment Act 1997 Subsection 995-1(1)