Private ruling: Issue of Redeemable Preference Shares
Published: July 2012
Ruling period: 1 July 2010 - 30 June 2021
Date scheme commenced: 1 December 2010

Ruling: Q1: Is the loss on the redeemable preference shares (RPS) deductible to the company under section 230-15 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes, the loss on the RPS is deductible to the company under section 230-15 of the ITAA 1997. | Q2: Is the accruals method the appropriate method for the company to apply to the loss on the RPS under subsection 230-100(2) of the ITAA 1997? | A2: No, the accruals method is not the appropriate method for the company to apply to the loss on the RPS.

Relevant facts and circumstances: Investors have subscribed for a combination of ordinary shares and RPS in a company. The key terms of the RPS are set out in documentation provided and forms part of the facts of the ruling. The company has made a valid election under subsection 230-455(7) of the ITAA 1997 to apply Division 230 to its financial arrangements. The company has not made any tax-timing method elections under Division 230 of the ITAA 1997. Assumptions The company will not make any tax-timing method elections for the purposes of Division 230 of the ITAA 1997 The annual compounded internal rate of return on the RPS will not exceed the benchmark rate of return (as defined in section 974-145 of the ITAA 1997) increased by 150 basis points There will be no material change to the RPS terms and conditions or circumstances in the future which may require a reassessment of the treatment of the RPS under Division 230 of the ITAA 1997 The company will redeem the RPS at maturity.

Relevant legislative provisions: Income Tax Assessment Act 1997 Division 230 Subdivision 230-A | Income Tax Assessment Act 1997 Section 230-15 | Income Tax Assessment Act 1997 Paragraph 230-15(1)(a) | Income Tax Assessment Act 1997 Paragraph 230-15(1)(b) | Income Tax Assessment Act 1997 Subsection 230-15(2) | Income Tax Assessment Act 1997 Subsection 230-15(4) | Income Tax Assessment Act 1997 Subsection 230-15(4A) | Income Tax Assessment Act 1997 Subsection 230-15(5) | Income Tax Assessment Act 1997 Section 230-40 | Income Tax Assessment Act 1997 Paragraph 230-40(1)(a) | Income Tax Assessment Act 1997 Paragraph 230-40(4)(e) | Income Tax Assessment Act 1997 Section 230-45 | Income Tax Assessment Act 1997 Subsection 230-45(1) | Income Tax Assessment Act 1997 Subsection 230-45(2) | Income Tax Assessment Act 1997 Section 230-50 | Income Tax Assessment Act 1997 Subsection 230-50(1) | Income Tax Assessment Act 1997 Section 230-55 | Income Tax Assessment Act 1997 Subsection 230-55(4) | Income Tax Assessment Act 1997 Section 230-85 | Income Tax Assessment Act 1997 Subdivision 230-B | Income Tax Assessment Act 1997 Section 230-105 | Income Tax Assessment Act 1997 Subsection 230-115(1) | Income Tax Assessment Act 1997 Subsection 230-115(2) | Income Tax Assessment Act 1997 Subsection 230-115(3) | Income Tax Assessment Act 1997 Section 230-185 | Income Tax Assessment Act 1997 Subsection 230-185(1) | Income Tax Assessment Act 1997 Section 230-455 | Income Tax Assessment Act 1997 Subsection 230-455(7) | Income Tax Assessment Act 1997 Section 974-20 | Income Tax Assessment Act 1997 Paragraph 974-20(1)(b) | Income Tax Assessment Act 1997 Paragraph 974-20(1)(c) | Income Tax Assessment Act 1997 Paragraph 974-20(1)(d) | Income Tax Assessment Act 1997 Paragraph 974-20(1)(e) | Income Tax Assessment Act 1997 Subparagraph 974-20(1)(c)(i) | Income Tax Assessment Act 1997 Subsection 974-20(4) | Income Tax Assessment Act 1997 Section 974-35 | Income Tax Assessment Act 1997 Subdivision 974-C | Income Tax Assessment Act 1997 Paragraph 974-70(1)(b) | Income Tax Assessment Act 1997 Subsection 974-75(1) | Income Tax Assessment Act 1997 Section 974-135 | Income Tax Assessment Act 1997 Subsection 974-135(5) | Income Tax Assessment Act 1997 Section 974-145 | Income Tax Assessment Act 1997 Paragraph 974-160(1)(a) | Income Tax Assessment Act 1997 Subsection 995-1(1) | Income Tax Assessment Act 1936 Subsection 6(1) | Income Tax Assessment Regulation 1997 Regulation 974-135C | Corporations Act 2001 Part 2H.2 | Corporations Act 2001 Section 254K

Reasons for decision: Summary: Yes, the loss on the RPS is deductible to the company under section 230-15 of the ITAA 1997. | Detailed Reasoning - Application of Taxation of Financial Arrangement (TOFA) rules: Subsection 230-15(2) of the ITAA 1997 provides that: "You can deduct a loss you make from a financial arrangement, but only to the extent that: you make it in gaining or producing your assessable income; or you necessarily make it in carrying on a business for the purposes of gaining or producing your assessable income." Accordingly, an amount will only be deductible pursuant to subsection 230-15(2) of the ITAA 1997 where it is a loss made from a financial arrangement. | Detailed Reasoning - Arrangement: The definition of 'financial arrangement' determines the unit of taxation in respect of which gains and losses are recognised under Division 230 of the ITAA 1997. In order to determine whether gains and losses arise under a financial arrangement, it is first necessary to establish whether the rights and obligations under consideration in the present circumstances give rise to an 'arrangement' that in turn meets the definition of a financial arrangement. The term 'arrangement' is defined in subsection 995-1(1) of the ITAA 1997 to mean any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings. As noted in paragraph 2.47 of the Explanatory Memorandum to the Taxation Laws Amendment (Taxation of Financial Arrangements) Act 2009 (the EM) generally a contract will constitute the relevant arrangement for TOFA purposes. However, section 230-55 of the ITAA 1997 contains grouping and disaggregation rules which may operate to group rights and obligations under a number of contracts into one arrangement, or alternatively to disaggregate rights and obligations into a number of arrangements. In the current circumstances, it must be considered whether the RPS constitutes one or more arrangements. Having regard to the factors in subsection 230-55(4) of the ITAA 1997, the RPS is considered to be a single arrangement. Under the RPS arrangement, the company has a right to receive the issue price of the RPS, and a contingent obligation to provide the redemption premium to investors on maturity. Further, the company has an obligation to pay dividends to investors, subject to the contingency that these dividends are declared by the Board. | Detailed Reasoning - Relevantly, section 230-85 of the ITAA 1997 provides:: "To avoid doubt: a right is treated as a right for the purposes of this Division even [if] it is subject to a contingency; and an obligation is treated as an obligation for the purposes of this Division even if it is subject to a contingency." Accordingly, where the rights and obligations under the arrangement are contingent rights and obligations, the contingency does not preclude those rights and obligations being rights and obligations for the purposes of Division 230. | Detailed Reasoning - Financial arrangement: Subdivision 230-A of the ITAA 1997 provides the test for determining whether an arrangement is a financial arrangement. Broadly, an arrangement will be a financial arrangement if it satisfies the definition of a financial arrangement under section 230-45 of the ITAA 1997, and/or the definition of a financial arrangement under section 230-50 of the ITAA 1997 (relating to equity interests). The RPS will be a financial arrangement under section 230-45 of the ITAA 1997 where the requirements in subsection 230-45(1) of the ITAA 1997 are met. Relevantly, subsection 230-45(1) provides that: · "You have a financial arrangement if you have, under an arrangement: · a cash settlable legal or equitable right to receive a financial benefit; or · a cash settlable legal or equitable obligation to provide a financial benefit; or · a combination of one or more such rights and/or one or more such obligations; · unless: · you also have under the arrangement one or more legal and equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and · for one or more of the rights and/or obligations covered by paragraph (d): · the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or · the right or obligation is not cash settlable; and · the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c). · The right, obligation or combination covered by paragraph (a), (b) or (c) constitutes the financial arrangement." Broadly, the RPS will constitute a section 230-45 financial arrangement if the rights and obligations under it are cash settlable within the meaning of subsection 230-45(2) of the ITAA 1997, and there are no 'not insignificant' rights and obligations under the arrangement which are not cash settlable. Further, the RPS arrangement will be a financial arrangement under subsection 230-50(1) if the RPS is an equity interest. Taxation Determination TD 2011/12, provides that where an arrangement satisfies the requirements under section 230-45 and subsection 230-50(1) of the ITAA 1997, the rules within Division 230 applying to section 230-50(1) financial arrangements prevail. | Detailed Reasoning - Is the RPS a section 230-50 financial arrangement?: In order to determine whether the RPS is a financial arrangement under subsection 230-50(1) it is first necessary to establish whether an RPS is an equity interest. 'Equity interest' is defined in subsection 995-1(1) of the ITAA 1997, and takes it's meaning as per Subdivision 974-C of the ITAA 1997. The test as to whether the RPS is an equity interest is found in subsection 974-75(1) of the ITAA 1997. The RPS will meet the equity test in this subsection, as it is an interest in the company as a member or stockholder of the company (Item 1 of subsection 974-75(1)). However paragraph 974-70(1)(b) of the ITAA 1997 provides that where an interest satisfies both the debt and equity tests, it is to be treated as a debt interest. Accordingly, we must consider whether the RPS meets the definition of a debt interest. Subsection 974-15(1) of the ITAA 1997 provides that a scheme will give rise to a debt interest in an entity if the scheme satisfies the debt test. The test for a debt interest is found in section 974-20 of the ITAA 1997. This section provides: · "(1) A scheme satisfies the debt test in this subsection in relation to an entity if: · the scheme is a financing arrangement for the entity; and · the entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme; and · 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: · the financial benefit referred to in paragraph (b) is received if there is only one; or · the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and · 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 · 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)…" As the RPS is an interest in a company that is covered by item 1 of the table in subsection 974-75(1) of the ITAA 1997, paragraph (a) does not need to be satisfied. Under the RPS, the company will receive a financial benefit, being the principal paid when the RPS is issued (paragraph 974-20(1)(b) of the ITAA 1997). Under the RPS, the company has an obligation to provide the principal amount of the RPS and the Redemption Premium to investors on Maturity. It must be considered whether these payments are 'effectively non-contingent obligations'. This term is defined in section 974-135 of the ITAA 1997, and requires that, in relation to the financial benefits to be provided, there is in substance or effect a non-contingent obligation. Under section 254K of the Corporations Act 2001 , a company is only able to redeem an RPS if the shares are fully paid-up, and out of profits or from the proceeds of a new issue of shares made for the purposes of the redemption. However, subsection 974-135(5) of the ITAA 1997 provides that 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. Should the company have insufficient profits at maturity date, the terms of the RPS allow them to undertake a share buy-back. Under section 257A of the Corporations Act 2001 , a company is permitted to undertake a share buy-back if the buy-back does not materially prejudice the company's ability to pay its creditors. Regulation 974-135C of the Income Tax Assessment Regulations 1997 provides that an obligation to redeem a preference share is not a contingent obligation merely because a requirement exists, under a law, to the effect that the redemption or buy back must not prejudice the company's ability to pay its creditors. On the basis of the terms to the RPS provided by the applicant, there are no other relevant contingencies that relate to the repayment of the principal, or the payment of the Redemption Premium on maturity. Accordingly, these are effectively non contingent obligations for the purposes for paragraph 974-20(1)(c) of the ITAA 1997, which are payable after the time the principal amount is received by the company under the RPS (subparagraph 974-20(1)(c)(i) of the ITAA 1997). When determining the value of the financial benefits provided, in accordance with subsection 974-20(4) of the ITAA 1997, only those financial benefits which are effectively non-contingent are included in the calculation. It should be noted that the obligation to provide annual dividends is a contingent obligation, as it is at the absolute discretion of the board. Section 974-35 of the ITAA 1997 provides that: · " (1) For the purposes of this Subdivision: · the value of a financial benefit received or provided under a scheme is its value calculated: · in nominal terms if the performance period (see subsection (3)) must end no later than 10 years after the interest arising from the scheme is issued; or · in present value terms (see section 974-50) if the performance period must or may end more than 10 years after the interest arising from the scheme is issued …" The term of the RPS is less than ten years. On that basis, the value of the financial benefits provided will be calculated in nominal terms. Paragraph 974-20(1)(d) of the ITAA 1997 requires that it is substantially more likely than not that the value provided will be at least equal to the value received. In the current circumstances, the company will receive the principal amount under the RPS, and will provide this amount to investors on maturity. Accordingly, it is substantially more likely than not that the value provided will be greater than the value received. Neither the value provided or received will be nil (paragraph 974-20(1)(e) of the ITAA 1997). Accordingly, as the requirements of section 974-20 are satisfied, the RPS will pass the debt test. As the RPS meets both the debt and equity tests, it will be treated as a debt interest by virtue of paragraph 974-70(1)(b) of the ITAA 1997. As the RPS does not represent an equity interest, it will not meet the definition of a financial arrangement in section 230-50 of the ITAA 1997. | Detailed Reasoning - Is the RPS a section 230-45 financial arrangement?: As noted above, broadly, an arrangement will be a financial arrangement under section 230-45 of the ITAA 1997 where the arrangement consists of cash settlable rights and obligations. The rights and obligations that arise under the RPS are rights or obligations to receive or provide financial benefits (as defined in paragraph 974-160(1)(a) of the ITAA 1997) for the purposes of section 230-45 of the ITAA 1997. The right to receive payments of principal when the RPS are issued are cash settlable as defined in subsection 230-45(2) of the ITAA 1997. Accordingly, this right satisfies paragraph 230-45(1)(a) of the ITAA 1997. Further, the obligation to make payments at maturity, and the contingent obligation to pay dividends to investors, are cash settlable as defined in subsection 230-45(2). Accordingly, these obligations satisfy paragraph 230-45(1)(b) of the ITAA 1997. There are no other rights and obligations under the RPS which are not insignificant and not cash settable. It follows that the requirements of section 230-45 of the ITAA 1997 are met, and the RPS arrangement will constitute a financial arrangement under section 230-45. | Detailed Reasoning - Deductibility under section 230-15: As noted above, subsection 230-15(2) of the ITAA 1997 will allow a deduction for a loss made under a financial arrangement, where the loss is made in gaining or producing assessable income, or where it is necessarily made in carrying on a business for the purposes of gaining or producing assessable income. As outlined in ATO Interpretive Decision 2012/19 ' Income tax: Taxation of financial arrangements: application of subsection 230-15(5) of the Income Tax Assessment Act 1997 to a dividend on a debt interest', a loss may not be deductible where it is in substance a distribution of profit as the liability to pay the amount may not be incurred in the course of deriving income. Such a loss would not have the requisite nexus to gaining or producing assessable income, as it constitutes the application of profits already derived. The definition of dividend in subsection 6(1) of the Income Tax Assessment Act 1936 includes monies paid by a company for the redemption of an RPS which is in excess of the paid up amounts. Accordingly, relevant payments by the company constitute a dividend, and as the RPS is a debt interest, it will constitute a dividend on a debt interest. Where the requirements in subsection 230-15(4A) are met, a dividend on a debt interest is deemed by that subsection to be a loss that can be deducted to the extent that loss would have been a deductible loss under subsection 230-15(2). In the current circumstances, it would be considered that the requirements of subsection 230-15(4A) are met, and the loss is not prevented from being deductible merely because it may be considered a distribution of post-derivation profits. Further, subsection 230-15(4) of the ITAA 1997 modifies the operation of subsection 230-15(2) of the ITAA 1997, providing that where one or more of the financial benefits taken into account in working out the loss from a financial arrangement are contingent on economic performance, this fact alone does not prevent deductibility under section 230-15(2) of the ITAA 1997. In the current circumstances, contingencies which relate to the requirement to redeem out of profits, or to ensure any payments do not materially prejudice other creditors, are considered to be contingent on economic performance. Because of subsection 230-15(4), the presence of these contingencies does not preclude deductibility under subsection 230-15(2) of the ITAA 1997. The extent to which a loss made can be deducted under subsection 230-15(2) is modified by subsection 230-15(5) of the ITAA 1997. That subsection provides that a deduction will not be allowable for a loss made to the extent to which the annually compounded internal rate of return on the debt interest exceeds the benchmark rate of return for the debt interest increased by 150 basis points. For the purposes of this ruling it is assumed that the internal rate of return on the RPS does not exceed the benchmark rate of return for the debt interest increased by 150 basis points. In the current circumstances, the loss on the RPS, being a dividend on a debt interest, is not precluded from being deductible due to the operation of subsections 230-15(4) and (4A) of the ITAA 1997. As the internal rate or return on the RPS is assumed to be less than the benchmark rate of return for the debt interest increased by 150 basis points, the loss is also not precluded from being deductible by the operation of subsection 230-15(5) of the ITAA 1997. | Detailed Reasoning - Conclusion: The RPS will be a financial arrangement for the purposes of section 230-45 of the ITAA 1997. The loss made under the financial arrangement will be deductible under subsection 230-15(2) of the ITAA 1997.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Question 1: Is the loss on the RPS deductible to the company under section 230-15 of the Income Tax Assessment Act 1997 (ITAA 1997)?