Private ruling: Application of the debt-equity rules under Division 974 of the ITAA1997
Date of advice: 5 September 2017
Published: December 2017
Ruling period: 1 July 2017 to 1 July 2019
Date scheme commenced: 1 July 2017

Ruling: Q1: Will the issue of D class ordinary shares by a company ( “Company Z” ) constitute “debt interests” rather than “equity interests” for the purposes of Division 974 of the Income Tax Assessment Act 1997 ( “ITAA 1997” )? | A1: Yes.

Relevant facts and circumstances: A group ( “the Group” ) engages in the business of the retail sale of new and used motor vehicles. The Group holds franchises to sell various brands of motor vehicles. The Group intends to form a consolidated group for the purposes of Division 703 of the ITAA 1997, with “ Company X ” as the head company of the group. Company X presently holds all of the shares in the companies which are intended to comprise the consolidatable group. “ Company Z ” is a franchisee and a proposed subsidiary member of the Group. A franchisor requires the dealer principal have a twenty (20) percent interest in the ordinary shares of the franchisee, Company Z. Accordingly, Company Z proposes to issue debt interest ordinary shares in Company Z to the dealer principal (as part of their terms of engagement and employment). The main rationale for issuing debt interests to the dealer principal is to ensure Company Z can still be a subsidiary member of the consolidatable group in due course. Specifically, the Directors of Company Z propose to make a resolution to issue “D class” ordinary shares to the new dealer principal on the following terms (the “Scheme” ): a) The shares will be part of and comprise a separate class of ordinary shares to be known as debt interest ordinary shares and identified as “D class” ordinary shares; and b) The shares will enjoy comparable rights to an ordinary share, except there is no equity participation right in relation to any surplus of assets over liabilities of Company Z (whether on winding up or any other basis); and c) The shares will carry the right to a non-cumulative dividend fixed at the rate of three (3) per cent per annum on the capital paid up on the shares; and d) The amount subscribed on the D class shares will be deemed a debt of the company, such that the subscribed capital will be repayable: (i) Upon winding up of the company or completion of the sale by the company of the whole of its assets; or (ii) Upon the cessation of employment of the dealer principal; or (iii) Upon such other events and in such other circumstances as the Directors in their discretion may determine; or (iv) In any event, and absent the earlier application of the above, nine (9) years after the date of issue of the shares. The terms upon which the D class shares are to be issued are set out in a draft Directors’ minute, a copy of which has been provided by the taxpayer.

Relevant legislative provisions: Income Tax Assessment Act 1997 , section 974-5. | Income Tax Assessment Act 1997 , section 974-15. | Income Tax Assessment Act 1997 , section 974-20. | Income Tax Assessment Act 1997 , section 974-35. | Income Tax Assessment Act 1997 , section 974-75. | Income Tax Assessment Act 1997, section 974-130. | Income Tax Assessment Act 1997 , section 974-135. | Income Tax Assessment Act 1997 , section 974-160.

Reasons for decision: Summary: Debt and equity interests Division 974 of the ITAA 1997 provides the mechanism for determining whether an interest is a debt interest or an equity interest for tax purposes. Subsection 974-5(1) of the ITAA 1997 provides that the test for distinguishing between debt interest and equity interests focuses on economic substance rather than mere legal form. Under subsection 974-5(4) of the ITAA 1997, an interest that can be characterised as both a debt interest and an equity interest will be treated as a debt interest for tax purposes. In the present case, the D class ordinary shares are equity interest as defined under subsection 974-70(1) of the ITAA 1997 because the issue of these shares is a scheme (as defined in subsection 995-1(1) of the ITAA 1997), that gives rise to an interest set out in the table contained in subsection 974-75(1) of the ITAA 1997. Specifically, it is an interest in the company as a stockholder of the company. It must also be determined whether the Scheme can be classified as a debt interest in order to determine whether the tie-breaker provisions will be enlivened. Debt interests Subsection 974-15(1) of the ITAA 1997 provides that a scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the 'debt test’ under subsection 974-20(1) of the ITAA 1997. The debt test is to be applied to the D class ordinary share when it is first issued. For present purposes, the Scheme will satisfy the debt test if: (a) the Scheme is a financing arrangement; and (b) Company Z receives or will receive a financial benefit under the Scheme; and (c) Company Z has an effectively non-contingent obligation (an “ENCO” ) under the Scheme to provide a financial benefit or benefits to one or more entities when the financial benefit is received; and (d) it is substantially more likely than not that the value provided will be at least equal to the value received (and the value provided and value received are not both nil). Is the Scheme a financing arrangement? A 'financing arrangement’ is defined under subsection 974-130(1) of the ITAA 1997 to include a scheme entered into or undertaken to raise finance for the entity. The Scheme will be a financing arrangement because the amount subscribed will be treated as a debt of the company. It will also be repayable on specific events happening. Thus, paragraph 974-20(1)(a) of the ITAA 1997 will be satisfied. Will Company Z receive a financial benefit under the Scheme? A 'financial benefit’ is defined broadly under subsection 974-160(1) of the ITAA 1997 to include 'anything of economic value’ including property and services. The price paid by the new dealer principal to acquire their D class ordinary shares will be a 'financial benefit’ received by Company Z. Thus, paragraph 974-20(1)(b) of the ITAA 1997 will be satisfied. Does Company Z have an ENCO to provide a financial benefit? ENCO is defined in section 974-135 of the ITAA 1997. Taxation Ruling TR 2008/3 further elaborates on the meaning of ENCO. Paragraph 34 of TR 2008/3 explains that the concept of ENCO is adopted to facilitate consideration of the economic substance of arrangements (i.e. by reference to the pricing, terms and conditions of the scheme). Therefore, where the provision of a financial benefit is formally subject to a contingency, that formal contingency may be disregarded if, upon consideration of the pricing, terms and conditions of issue, the substance or effect of the arrangement is that the financial benefit will be provided by the issuer, despite the formal contingency. The draft Directors’ Minute provides the terms of issue of the D Class ordinary shares. Specifically, it states that Company Z has an obligation to return the issue price of the share to the shareholder: (i) Upon winding up of the company or completion of the sale by the company of the whole of its assets; or (ii) Upon the cessation of employment of the dealer principal; or (iii) Upon such other events and in such other circumstances as the Directors in their discretion may determine; or (iv) In any event, and absent the earlier application of the above, nine (9) years after the date of issue of the shares. Subsection 974-135(6) of the ITAA 1997 states 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. Based on the terms of issue, the contingencies tend to indicate that there is, in substance and effect, a non-contingent obligation for Company Z to return the issue price of the shares to the dealer principal. Notwithstanding whether the earlier events have any application, the subscribed capital will still be repaid nine years after the date of issue. Therefore, paragraph 974-20(1)(c) of the ITAA 1997 will be satisfied. Value provided vs. value received Given the above conditions have been satisfied, the Scheme will satisfy the debt test if it is substantially more likely that not that the value provided by Company Z will be at least equal to the value received from the new dealer principal. In assessing the 'values provided’ and 'value received’ under a scheme, subsection 974-20(2) of the ITAA 1997 states that the 'value provided’ is the total values of all financial benefits provided under the scheme by the entity. Similarly, subsection 974-20(3) of the ITAA 1997 provides that the 'value received’ is the total values of all financial benefits received, or to be received, under the scheme by the entity. The D class ordinary shares will carry the right to a non-cumulative dividend fixed at the rate of three percent per annum on the capital paid up on the shares. Additionally, Company Z will repay the issue price of the shares to the dealer principal no later than 9 years after the issue of the shares. Therefore, pursuant to subparagraph 974-35(1)(a)(i) of the ITAA 1997, the value of the financial benefit will be calculated in nominal terms. Since the repayment will be the subscribed capital amount which equals to the financial benefit received, the test will be satisfied. It can also be said that it is substantially more likely than not that the value of the financial benefits provided will equal or exceed the value of the financial benefit received. Further, the value provided and value received are not both nil. Therefore, paragraphs 974-20(1)(d) and (e) of the ITAA 1997 will be satisfied. Conclusion Accordingly, the issue of D class ordinary shares by Company Z to dealer principal will be classified as a debt interest under section 974-20 of the ITAA 1997. Although the issue of D class ordinary shares also satisfies item 1 of the table in subsection 974-75(1) of the ITAA 1997, those shares cannot give rise to an equity interest as they are characterised as a debt interest (refer to paragraph 974-70(1)(b) of the ITAA 1997).