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Debt/Equity:Recent Developments

Presented by

Martin Fry and Brad Schwarz

(December 2005)

Martin FryPartner

Allens Arthur RobinsonMelbourne

Brad SchwarzSenior Associate

Allens Arthur RobinsonMelbourne

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Table of Contents

1. Debt/Equity in Context 32. This Paper 43. Debt/Equity Outline 5

3.1 Objects of Division 974 53.2 Equity 63.3 Debt 6

4. Experiences in Other Countries 84.1 New Zealand 84.2 Canada 94.3 United States of America 104.4 Australian Perspective 12

5. TD 2004/D76: Issuer's option to convert 145.1 Scope of the Willingness Exception 155.2 Reclassify 17

6. Solvency Clauses 187. Section 974-80 20

7.1 Conceptual 207.2 Limbs of Section 974-80 207.3 The Equity Limb 217.4 Designed to Operate 227.5 Third Party Finance 247.6 Another Person 267.7 Apportionment 26

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1. Debt/Equity in Context

The distinction between debt and equity is of fundamental importance in moderncommercial activity. One of the core principles upon which financial accommodation isobtained for commercial ventures is that those exposed to the risk of the venture failingshould also be entitled to the fruits of the venture's success, whilst those having the benefitof protection from failure should therefore be excluded from the fruits of success. Withinthis broad spectrum, parties come together to participate in commercial ventures andmyriad financial arrangements are created under which the risks and rewards of theventure are allocated amongst the participants on the basis of their respective appetites forrisk and reward.

This allocation of risk and reward determines at a basic level whether we regard anyparticular party as an equity participant or debt participant in the venture. The reality ofmodern financial arrangements is that any particular party will often have a mixture ofequity-like and debt-like exposures to the venture.

A fundamental question for regulators is whether financial arrangements should be viewedas a whole from a debt/equity perspective, or whether financial arrangements should bedissected into their separate 'debt parts' and 'equity parts'. Once it has been decided thatfinancial arrangements should be viewed as a whole, the challenge is to appropriatelycharacterise the overall arrangement as debt or equity having regard to the inevitable mixof equity and debt exposures.

Although the task of characterising arrangements as debt or equity will often be difficult, thedebt/equity distinction continues to be a key area of focus in the Australian economy.Ratings agencies and prudential regulators such as APRA closely monitor the debt toequity ratios of Australian corporations. When accountants draw up financial accounts fora corporation they record the levels of debt and equity, and this information is relied uponby the investment market.

The distinction between debt and equity is alive in many aspects of our income tax laws.

Division 974 of the Tax Act 1997 provides a code for determining whether a scheme is tobe characterised as debt or equity for some but not all income tax purposes. Division 974is generally relevant for the purposes of the following (which is not an exhaustive list):

(a) dividend imputation (section 202-40 and Division 215 of the Tax Act 1997);

(b) dividend and interest withholding tax, including the interest withholding taxexemption for public offers (sections 128A(1), (1AB) and 128F of the Tax Act1936);

(c) thin capitalisation (Division 820 of the Tax Act 1997);

(d) certain deduction provisions (sections 25-85 and 26-26 and of the Tax Act 1997;

(e) the non-share capital account (Division 164 of the Tax Act 1997);

(f) membership interests for tax consolidation purposes (section 960-130 of the TaxAct 1997);

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(g) exempting company provisions (section 208-30 of the Tax Act 1997, but note theextension of the debt/equity distinction in section 208-30(6));

(h) assessment of dividend income under section 44 of the Tax Act 1936;

(i) taxation of tax exempt bonus shares (section 6BA of the Tax Act 1936);

(j) commercial debt forgiveness provisions (Division 245, Schedule 2C of the Tax Act1997);

(k) tax file number provisions (section 202D of the Tax Act 1936).

However, at the same time the debt/equity distinction provided by Division 974 has no roleto play in many instances in which the distinction between debt and equity is relevant to theapplication of our tax laws. For example, the debt/equity distinction under Division 974 hasno role to play in relation to the following:

(a) scrip for scrip rollover relief (Division 124-M of the Tax Act 1997);

(b) grouping other than for the purposes of tax consolidation (eg, CGT rollover reliefunder Division 126-B of the Tax Act 1997);

(c) controlled foreign company provisions (Part X of the Tax Act 1936);

(d) the CGT participation exemption (Division 768 of the Tax Act 1997);

(e) accruals taxation under Division 16E of the Tax Act 1997;

(f) the definition of a 'qualified person' for the purposes of the franking provisions (PartIIIAA, Division 1A of the Tax Act 1936 as at 30 June 2002);

(g) the exemptions provided by sections 23AJ, 23AI and 23AK of the Tax Act 1936.

2. This Paper

This paper will focus on the debt/equity distinctions contained in Division 974 of the Tax Act1997.

The purpose of this paper is to provide commentary on recent developments in theapplication of Division 974 and to comment on experiences in dealing with the distinctionbetween debt and equity in certain foreign jurisdictions.

Part 3 of this paper provides a brief summary of the debt/equity distinction in Division 974.The distinction has also been well described in other places, such as the recent articles byGarry Bourke1 and Stuart O'Neill2.

Part 4 of the paper then briefly considers the debt/equity experience in the United States,Canada and New Zealand, and reflects upon these experiences in the context of Division974.

Part 5 provides a critique of the Draft Taxation Determination TD 2004/D76.

1 'Drawing a sharp line in the sand of the debt/equity desert – Division 974 Oasis or Mirage?' (2004) 33 Australian TaxRev 24.2 'Criticisms of the Debt-Equity Rules and their Application to Modern Financial Instruments', The Tax Specialist, Vol. 6 No4, April 2003.

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Part 6 is a discussion of so-called solvency clauses and the announced proposal to dealwith the issues raised by such clauses.

Finally, Part 7 of this paper discusses the ambit of section 974-80.

In this paper, all statutory references are to the Income Tax Assessment Act 1997 (Tax Act1997) or the Income Tax Assessment Act 1936 (Tax Act 1936), unless stated otherwise.

3. Debt/Equity Outline

Division 974 of the Tax Act 1997 contains prescriptive rules to determine what constitutesdebt and what constitutes equity in a company for certain income tax purposes. In broadterms, the objective of these rules is to characterise instruments on the basis of theireconomic substance rather than on the basis of their legal form. Consequently,instruments which in form are equity may be characterised as debt under Division 974, andinstruments that are in form debt can be characterised as equity.

A flow chart of the debt/equity distinction in Division 974 is set out in Appendix 1.

As a general proposition, if an interest satisfies the debt test, distributions paid on thatinterest may be deductible but not frankable and will potentially be subject to interestwithholding tax. Conversely, distributions paid on equity interests may be frankable but notdeductible and will potentially be subject to dividend withholding tax.

The key question in characterising an instrument as debt or equity is whether the issuer ofthe instrument has an effectively non-contingent obligation to pay back an amount thatis at least equal to the amount it received in connection with the issuance of the instrument.If there is such an obligation, the instrument is treated as debt. If there is no suchobligation the instrument will be treated as equity if it represents the interest of a memberof the issuer, now or in the future, or if the return on the instrument is contingent on theissuer in certain respects. There is scope for overlap between the debt and equitydefinitions. If an instrument satisfies both definitions, it is treated as debt. In conductingthe task of characterising an instrument it is necessary to have regard to relatedarrangements.

As for the meaning and application of effectively non-contingent obligation, thisexpression is currently the subject of debate. We have considered its meaning andapplication in Parts 5 and 6 of this paper in the context of convertible notes and solvencyclauses.

3.1 Objects of Division 974

The stated objects of Division 974 are:

(a) to establish a test for determining for particular tax purposes whether a scheme orthe combined operation of a number of schemes gives rise to a debt interest or anequity interest;

(b) that the test operates on the basis of economic substance rather than on the basisof mere legal form (by reference to the impact on the issuer's position);

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(c) that the combined effect of related schemes be taken into account in appropriatecases (to ensure that the test operates effectively on the basis of economicsubstance and to prevent the test being circumvented by entering into separateschemes); and

(d) to identify the distributions and credits made in respect of non-share equityinterests in a company that are to be treated as dividends and those that are to betreated as returns of capital.

In making various determinations under Division 974, the Commissioner must have regardto these stated objects (section 974-10).

3.2 Equity

Section 974-75 lists the following four categories of interests in relation to a company whichare treated as equity:

(a) An interest in a company as a member or stockholder.

(b) An interest carrying a right to a variable or fixed return if either the right itself or theamount of the return is in substance or effect contingent on the economicperformance of the company, a part of the company’s activities or a connectedentity of the company.

(c) An interest that carries a right to a variable or fixed return if either the right itself orthe amount of the return is at the discretion of the company or a connected entityof the company.

(d) An interest issued by a company that gives the holder (or a connected entity of theholder) a right to be issued with an equity interest in the company or in a connectedentity of the company, or that will or may convert into an equity interest in thecompany or a connected entity of the company.

For interests other than an interest in a company as a member or stockholder, to constitutean equity interest, the particular scheme under which the interest arises must involve afinancing arrangement. That concept is very broadly defined. Basically, a scheme is afinancing arrangement if it is undertaken to raise finance for the entity or for a connectedentity (section 974-130).

An equity interest can arise under a single scheme. It is also provided that two or morerelated schemes are taken together to give rise to an equity interest in a company if ascheme with the combined effect of the constituent schemes would give rise to an equityinterest and it is reasonable to conclude that the company intended, or knew that a party tothe schemes intended, that the combined economic effect of the constituent schemeswould be the same as, or similar to, the economic effects of an equity interest (section 974-70).

3.3 Debt

According to section 974-20, a scheme satisfies the debt test in relation to an entity if:

(a) it is a financing arrangement for the entity (financing arrangement has the samemeaning in this context as it does for the purpose of the equity interest definition);

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(b) the entity, or a connected entity, receives or will receive a financial benefit underthe scheme;

(c) the entity, or the entity and a connected entity, has an effectively non-contingentobligation to provide a financial benefit after the time when it first receives afinancial benefit;

(d) it is substantially more likely than not that the value provided by the entity will beat least equal to the value it received; and

(e) the value provided and the value received are not both nil.

As discussed above in relation to equity interests, debt interests can arise under a singlescheme or under related schemes the combined effect of which, and the intention of which,is to create a debt interest.

Financial benefit is defined as meaning anything of economic value, and includesproperty and services (section 974-160). The issuing of an equity interest does notconstitute the provision of a financial benefit (section 974-30). Therefore, the issuance ofan equity interest on conversion of a convertible note would not be taken into account indetermining whether the issuer has an effectively non-contingent obligation to providefinancial benefits at least equal to the benefits it receives.

An obligation to take a particular action is effectively non-contingent if, having regard tothe pricing, terms and conditions of the scheme there is in substance or effect a non-contingent obligation to take that action (sub-section 974-135(1)). As this is a key conceptin Division 974, there are also a number of specific rules on whether a particular obligationis to be regarded as effectively non-contingent. In particular:

(a) An obligation is taken to be non-contingent if is not contingent on any event,condition or situation other than the ability or willingness of the entity to meet theobligation (sub-section 974-135(3)).

(b) Obligations to redeem preference shares are not taken to be contingent merelybecause there is a legislative requirement to redeem the shares out of profits orfrom the proceeds of a further issuance of shares (sub-section 974-135(5)).

(c) The fact that the holder of an interest that is convertible into equity has a right toconvert the interest into equity does not of itself make the issuer’s obligation torepay the interest contingent (sub-section 974-135(4)). For example, the issuer ofa convertible note where the issuer has an obligation to repay the amount raisedon issuance may have a non-contingent obligation to repay that amount eventhough the holder may be entitled to exercise a conversion right at specified timesduring the term of the note.

(d) An obligation is not taken to be effectively non-contingent merely because theissuer will suffer a detrimental practical or commercial consequence if theobligation is not fulfilled (sub-section 974-135(7)). In this context, the legislationuses income securities as an example. It states that if there is a contingentobligation to make payments on income securities (eg. interest is only payable ifsufficient profits are available), the obligation to make payments is not non-

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contingent merely because non-payment would have a detrimental effect on theissuer’s business.

(e) In determining whether there is in substance or effect a non-contingent obligation,it is necessary to have regard to the artificiality or the contrived nature of anycontingency on which the obligation to take the action depends (sub-section 974-135(6)).

Division 974 contains rules for valuing financial benefits. This is important in determiningwhether it is substantially more likely than not that the value of the benefits to be providedby the issuer will at least equal the value of the financial benefits received.

If the issuer has an effectively non-contingent obligation to provide financial benefits inrelation to an interest no later than 10 years after the interest is issued, the value of thosefinancial benefits is to be calculated in nominal terms (section 974-35). If there is anobligation to provide benefits for a period exceeding 10 years from the date of issue, thevalue of the benefits is determined in present value terms. For this purpose, futurepayment streams are discounted at a rate equal to 75 percent of the rate of interest paid onthe issuer’s ordinary debt (section 974-50).

4. Experiences in Other Countries

It is instructive to consider the approach to the debt/equity distinction in other countries.

4.1 New Zealand

The New Zealand tax system has featured an accruals taxation regime for some time, andthe New Zealand approach to the debt/equity distinction is encapsulated in the carve outfrom accruals taxation that is provided for shares and certain interests in shares.

The accruals regime applies to 'financial arrangements', which are very broadly defined toinclude an arrangement under which a person receives anything of value in considerationfor a person providing in the future anything of value to any person3. However, anarrangement is then carved out of the accruals regime if it is covered by one of the 22'excepted financial arrangements'. The list of 'excepted financial arrangements' includesshares (defined to include any interest in the capital of a company, and certain debentures)and certain options to buy or sell shares4.

When considered in light of the Australian debt/equity distinction in Division 974, the moststriking aspect of the New Zealand approach is the fact that the 'equity' carve out reliesupon the legal form of the instrument. The issues which arise under Division 974 inapplying the 'effectively non-contingent obligation' test and other tests based upon theeconomic substance of the arrangements do not have a significant role to play in the NewZealand debt/equity distinction.

3 Section EW3(1), (2), Income Tax Act 2004.4 Sections EW4, EW5, Income Tax Act 2004.

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As noted by Bourke5, it is interesting to note that under the Australian debt/equitydistinction in Division 974 an instrument which satisfies both the debt test and the equitytest will be classified as debt (sections 974-70(1)(b) and 974-80(2)), whereas under theNew Zealand approach 'equity' instruments (specifically, shares and certain options to buyor sell shares) are carve out of the accruals regime for 'financial arrangements'.

It has been suggested that the New Zealand approach of specific carve-outs gives thelegislature the flexibility to respond to the development of new forms of financialinstruments in the market over time6.

This is also a feature of the Australian debt/equity distinction in Division 974, with theCommissioner having the power to make regulations in relation to many aspects of thedebt/equity distinction (refer sections 974-10(6), 974-20(6), 974-90, 974-135(8), 974-140(2), 974-145(3), 974-150(4), 974-155(4) and 974-160(3)). The current proposals todeal with so-called 'solvency clauses' is evidence of this feature at work – refer Part 6 ofthis paper below.

However, a related aspect of the Australian debt/equity Rules can only be viewed asnegative. Specifically, the ability of the Commissioner to determine the debt/equityclassification notwithstanding the classification that is achieved by the debt and equity testsset out in Division 974 introduces an unnecessary degree of uncertainty into the Australianregime (refer sections 974-15(4), 974-65, 974-70(4) and 974-150(2); the Commissioner'sdetermination under section 974-60 is perhaps not subject to this criticism).

4.2 Canada

The Canadian tax laws contain provisions which apply debt tax treatment to certainpreference shares7. Specifically, certain preferred shares are deemed to be debt for taxpurposes where the terms and conditions of the share issue make it 'reasonable to expect'that the issuer or a related person will redeem, acquire or cancel the share.

As noted by Bourke, the Canadian concept of 'reasonable to expect' may well be a bettervehicle for giving recognition to the economic substance of an arrangement than is theAustralian 'effectively non-contingent obligation' test, as the use of the legal term'obligation' in the Australian test is more likely to give prominence to the legal form of thearrangement.

It is noted that the Canadian test focuses on the likelihood of redemption, and theAustralian debt test, broadly speaking, focuses on whether there is an effective obligationfor the issuer to return the investor's investment by way of redemption or coupons. Thisfocus on the likelihood of the issuer returning the funds invested is in contrast to theapproach of the Full Federal Court in FCT v Radilo Enterprises Pty Ltd 97 ATC 4123,where the question of the issuer having an obligation to redeem the preference shares was

5 G Bourke, 'Drawing a sharp line in the sand of the debt/equity desert – Division 974 – Oasis or Mirage?' (2004) 33Australian Tax Review 24.6 Smith 'AMC New Zealand – Taxation of Financial Instruments' (1999) 6 (Nov/Dec), Derivatives and Financial Instruments(IBFD Publications BV), cited in Bourke at note 81.7 Bourke, (2004) 33 Australian Tax Review 24 at p.50.

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one factor taken into account, but where the court placed far more emphasis on thebroader question of whether a relationship of creditor and debtor existed between theissuer and the investor.

4.3 United States of America

The approach to the debt/equity distinction in the United States provides a stark contrast tothe Australian approach in Division 974.

In broad terms the distinction between debt and equity for US tax purposes is determinedby a 'facts and circumstances' approach8. Under this approach the courts extract theequity-like characteristics and the debt-like characteristics of an arrangement, weigh upthese characteristics amongst each other, and then determine whether the arrangement isdebt or equity without regard to any single articulated principle.

The following statement has been cited in the US courts as the classic statement of thatwhich differentiates a shareholder from a creditor9:

… the shareholder is an adventurer in the corporate business; he takes risks, andprofits from success. The creditor, in compensation for not sharing in profits, is to bepaid independently of the risk of success, and gets a right to dip into the capital whenthe payment date arrives.

It has been suggested that this and other judicial pronouncements provide no meaningfulguidance on how to distinguish between debt and equity for the purposes of US law10.Indeed, the state of the law in the US on the debt/equity distinction has been described inthe following terms11:

… because of the wide variety of instruments and transactions that have requiredclassification as debt or equity, the courts have spawned a bewildering variety oftests and standards requiring highly fact-bound and uncertain legal determinations.One commentator counted thirty-eight different factors that had been considered bythe courts in trying to classify an interest as debt or equity. Another stated that "[t]olook to the case law for guidance is to invite bewilderment. … You can find a casewhich supports almost any reasonable argument." Finally, a district court judgestated that the distinction was reminiscent of Justice Stewart's well-known "definition"of pornography12

The 'thirty-eight factors' referred to above were as follows:

8 Katherine Pratt 'The Debt-Equity Distinction in a Second-Best World', Vanderbilt Law Review, Vol 53, No 4, May 2000;Gordon Longhhouse, 'Making the Line a Gap: Edgar's Treatment of the Debt-Equity Boundary', Canadian Tax Journal(2002) Vol. 50 No 1, 239.9 Adam Emmerich, 'Hybrid Instruments and the Debt-Equity Distinction in Corporate Taxation', University of Chicago LawReview, Vol 52, 1985, 118 at p.121 and note 42; quote from the decision in Commissioner v OPP Holding Corp 76 F.2d 11(2d Cir 1935).10 Emmerich at p.127.11 Emmerich at p.127.12 Sansberry v United States, 25 A.F.T.R.2d (P-H) ¶ 70-394, at 70-622 n.4 (S.D. Ind. 1970) (citing Jacobellis v Ohio, 378U.S. 184, 197 (1964) (Stewart, J., concurring) ("I know it when I see it …"); see also Plumb, supra note 5, at 370-71(discussing the "jungle" of conflicting decisions and criteria).

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… formal authorisation of "debt"; ascertainable principal amount; time to maturity;postponement of stated maturity; default provisions; default provisions not beinginvoked; specificity of interest provisions; source of interest; discretion of obligor inpaying interest; "understanding" as to nonobservance of terms; cumulativeness ofinterest; possibility of unilateral modification; specificity of rights upon dissolution;subordination; dependency of repayment on success of business venture; identity ofinterest between stockholders and bondholders; nature of creditor; dependency ofinterest upon director action; participation of bonds in profits; creditor participation inmanagement; package financing of the corporation; whether debt was really aconversion of equity; whether the original capital was adequate; timing of the creationof the indebtedness; thinness of capital; form of the instrument; uncertainty of obligoras to what the security is; ability of borrower to borrow from nonstockholders;creditors expectation of repayment; how the obligor carried "debt" on its books;corroborative evidence; convertibility of indebtedness; nomenclature; industrypractice; whether the indebtedness was secured; existence of a sinking fund; patternof stockholder borrowing; and intent13.

It is interesting to note that a number of the thirty-eight factors are also features of the debttest or equity test in Division 974.

A review of the literature in relation to the US debt/equity distinction reveals the consistentcriticism that the 'facts and circumstances' approach produces an unacceptable level ofuncertainty and associated compliance costs. On the other hand, and relevantly in thecontext of the 'sharp line' approach to the debt/equity distinction that is adopted in Division97414, it is also said that the key benefit of the US 'facts and circumstances' approach isthat it avoids the financial engineering that naturally follows from having a 'sharp' dividingline between debt and equity15.

Over time we will know whether the comprehensive set of rules contained in Division 974deliver a materially better outcome than the much more fluid 'facts and circumstances'approach. However, it is most relevant to note that the US regulators have previouslyattempted to establish a 'sharp line' distinction between debt and equity. This occurred in1980 when, pursuant to section 385 of the US tax code16, regulations were proposed toprovide guidelines for classifying instruments as debt or equity for tax purposes. In relationto 'hybrid instruments' the proposed regulations provided that the instrument would be debtif its 'debt features' accounted for more than 50% of the value of the instrument. The 'debtfeatures' were effectively defined to be the present value of the fixed or guaranteedamounts payable under the instrument17.

The investment market responded to the proposed regulations in the early 1980s bycrafting hybrids then known as 'adjustable rate convertible notes', which provided for

13 Emmerich at note 43, citing Holzman, The Interest-Dividend Guidelines, 47 Taxes 4 883, 885 (1969).14 Bourke, at p.26.15 Gordon Lighthouse, 'Making the Line a Gap: Edgar's Treatment of the Debt-Equity Boundary', Canadian Tax Journal,2002 Vol. 50, Iss. 1, p.238; Tim Edgar 'The Income Tax Treatment of Financial Instruments: Theory and Practice', CanadianTax Paper no. 105, Canadian Tax Foundation, 2000.16 IRC s.385(a); refer also Pratt at notes 106 to 116.17 Emmerich at pp 130-133.

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guaranteed payments having a present value marginally exceeding 50% of the value of thenotes, but which also provided for variable payments linked to the issuers' dividends andwhich were convertible into ordinary shares18. The IRS responded to this development byissuing Revenue Ruling 83-98 in which it advised that the adjustable rate convertible noteswere to be treated as equity for tax purposes on the basis that the notes were virtuallycertain to be converted to shares and that the debt features were of little 'practical oreconomic significance'19. However, having deferred the commencement date for theRegulations, the IRS then retreated from the 'sharp line' approach entirely when it withdrewthe Regulations in 1983 and the US tax law on the debt/equity distinction returned to themurky waters of the 'facts and circumstances' approach20.

The lesson to be gained from the 'section 385 experiment' in the US is that the Australianrevenue authorities should not be surprised if the market responds to the prescriptivedebt/equity distinction in Division 974 by placing a greater emphasis on financialengineering, and perhaps legal form, in constructing hybrid financial instruments.

Interestingly, Gordon Mackenzie of the University of New South Wales has conducted anempirical study from which he draws the conclusion that the introduction of Division 974has been substantially responsible for the increase in the issuance of hybrids in the periodsince 200121. Of course, an increase in the issuance of hybrids should not necessarily beviewed as a negative by revenue authorities, as the hybrid instrument provides a means ofeffective risk allocation for certain market participants. Indeed the Australian revenueauthorities may even wish to assert that an increase in hybrid issuance is evidence ofDivision 974 providing certainty and clarity on the debt/equity distinction!

4.4 Australian Perspective

When one considers the approaches to the debt/equity distinction in the US, New Zealandand Canada, the Australian debt/equity distinction in Division 974 is remarkablycomprehensive and prescriptive. In particular, the machinery, concepts and complexitiesof Division 974 of the Tax Act 1997 are extraordinary when one considers that the US taxsystem survives with the bare minimum of guidance from the legislature.

This raises the question of whether it is really necessary for the Australian tax laws to besaddled with such a comprehensive and involved code for distinguishing between debt andequity for tax purposes. In this respect the following thoughts are offered.

First, whilst Division 974 of the Tax Act 1997 provides a detailed and prescriptive code fordistinguishing between debt and equity, the characterisation of an instrument underDivision 974 has not been comprehensively integrated into our tax laws. It is suggestedthat the legitimacy of the comprehensive approach embodied in Division 974 could only be

18 Emmerich at p.131, citing Borg-Warner Corporation Prospectus 2 December 1982.19 Emmerich at pp.131-132.20 Emmerich at p.132; Longhouse at note 27; Bourke at p.31; Pratt at p.1083 and note 115.21 Gordon Mackenzie, 'Impact of new debt/equity rules on the hybrid capital market an empirical study', Australian Bankingand Finance Law Bulletin, Vol. 20 No. 7, January 2005.

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established if the debt/equity characterisation under Division 974 were to be appliedcomprehensively throughout the Tax Act 1997 and the Tax Act 1936.

Second, it is relevant to recall that legislative rules to distinguish between debt and equityexist partly in response to the difference in the after-tax cost of debt funding and equityfunding.

In jurisdictions where there is no general tax relief for dividends received, such as theUnited States, there continues to be a comparatively large difference in the after-tax cost ofdebt funding compared to equity funding. By contrast, in Australia the after-tax cost of debtfunding and equity funding is more closely aligned. This is a consequence of theAustralian dividend imputation rules, which provide the shareholder with a credit for the taxpaid at the entity level. It is also a consequence of the preference provided to the taxationof value gains in the hands of equity holders. That is, in comparative terms equity interestspay more of their returns as capital gains than do debt interests, and such capital gains areonly taxed in the hands of equity holders upon realisation of the capital gain. Even then,the equity holder's capital gain will often be entitled to the benefit of the CGT discounts(refer Division 115 of the Tax Act 1997).

Hence, in circumstances where the gap between the after-tax cost of debt funding andequity funding is comparatively narrow, is there a case for the Australian tax laws tocontain the comprehensive code embodied in Division 974? In other words, considerationshould be given to the question of whether the prospects of parties engaging in domesticdebt/equity arbitrage are sufficient to justify the comprehensive and complex approachadopted in Division 974.

Third, as Bourke points out, the debt/equity distinction in Australia is out of alignment withother major countries22. A disparity in treatments between two jurisdictions will, of course,create the opportunity for cross-border debt/equity arbitrage. As put by Rosenbloom:

Whenever a country adopts a rule that is either difficult to replicate or apply (forexample the US rules for distinguishing debt from equity) or markedly out of step withwhat other countries do or are likely to do, a breeding ground for arbitrage is created.

The next issue to consider in this context is whether international arbitrage should orshould not be a concern for the legislature of any one country. If a financial arrangementsatisfies the criteria for classification of debt or equity for Australian tax purposes, do theAustralian Parliament or revenue authorities have any legitimate concern if the samearrangement is treated in a different way for tax purposes in another country? That topic isbeyond the scope of this paper, however Rosenbloom's analysis of this issue isrecommended23.

22 Bourke, at p.26.23 Rosenbloom HD, 'International Tax Arbitrage and the International Tax System'. NYU 1999-2000 53 Tax Law Review153.

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5. TD 2004/D76: Issuer's option to convert

Section 974-20 of the Tax Act 1997 contains five key tests that must be satisfied in orderfor an interest in an entity to be treated as debt. One of those tests is that the entity musthave an effectively non-contingent obligation to provide a financial benefit or benefits(sub-section 974-20(1)(c) of the Tax Act 1997). This part of the paper considers theapplication of this test in the context of an interest bearing convertible note.

In this regard, Draft Taxation Determination TD 2004/D76 (Draft Tax Determination)raises the following question: for the purposes of Division 974 of the Income TaxAssessment Act 1997, does an issuing company have an effectively non-contingentobligation to provide a financial benefit by way of periodic interest returns on an interestbearing convertible note from the time that it can be converted at the issuing company'soption into ordinary shares in that company?

The answer provided is: no, unless the option to convert should be disregarded in light ofthe full consideration of the pricing, terms and conditions of the scheme under which theconvertible note was issued.

The significance of this interpretation can be illustrated as follows:

(a) On 17 November 2005 - a company (issuer) issues convertible notes. Under theterms of the notes, the issuer is required to pay periodic coupons at a fixed rateuntil the notes convert into ordinary shares, which may occur at the issuer's optionat any time on or after 17 November 2011.

(b) On 17 November 2011 - the option to convert the convertible notes into ordinaryshares crystallises (that is, the issuer can exercise the option at any time).

(c) On 17 November 2014 - the issuer exercises the option and converts theconvertible notes into ordinary shares.

The Draft Tax Determination correctly notes that the requirements of section 974-20 mustbe tested at the date of issue of the convertible note.

According to the Draft Tax Determination, the issuer will cease having an effectively non-contingent obligation to pay the coupons on the convertible notes from 17 November 2011.That is, from the time the option to convert the convertible notes into ordinary sharescrystallises, even though it may ultimately be the case that the issuer continues to pay thecoupons and the actual conversion does not occur until three years later. The reason forthis, according to the Draft Tax Determination, is that at the time the option crystallises thepayment of the coupons becomes contingent upon the issuer not exercising the option and,

17 November 201417 November 201117 November 2005

Company issuesconvertible notes

Company has option to convertconvertible notes into ordinary

shares

Companyexercises option

mafm M0111800265v1 150630 21.12.2005 Page 15

therefore, not converting the convertibles notes into ordinary shares (paragraph 9 of theDraft Tax Determination).

The potential implications of the Draft Tax Determination are:

(a) if the convertible notes do not otherwise satisfy the debt test under Division 974 atthe time of issue24 - the effect of the Draft Tax Determination would mean that theconvertible notes would be treated as equity from the outset, even though thenotes had a clear debt like character at least until 17 November 2011;

(b) if the convertible notes otherwise satisfy the debt test under Division 974 at thetime of issue25 – the effect of the Draft Tax Determination would mean that thenotes will lose their status as debt at the time the issuer can exercise the option (ie.from 2011) as there would no longer be a debt interest on issue (section 974-55(1)(e)). Consequentially, the notes may be treated as equity and the payment ofthe coupons may no longer be deductible, but may be frankable, from17 November 2011 to 17 November 2014 (section 26-26).

It is questionable whether the interpretation adopted in the Draft Tax Determinationadequately takes into account the requirements set out in section 974-135 and the otherprovisions in Division 974.

5.1 Scope of the Willingness Exception

According to sub-section 974-135(1), there is an effectively non-contingent obligation totake an action under a scheme if, having regard to the pricing, terms and conditions of thescheme, there is in substance or effect a non-contingent obligation to take that action.According to sub-section 974-135(3), an obligation is non-contingent if it is not contingenton any event, condition or situation (including the economic performance of the entityhaving the obligation or a connected entity of that entity), other than the ability orwillingness of that entity or connected entity to meet the obligation.

It is evident from the wording in sub-section 974-135(3) that, in order for an obligation to benon-contingent, all events, conditions or situations must be taken into account other thanthe ability or willingness of the entity or connected entity to meet the obligation. In otherwords, the section contains a positive limb and a negative limb. The positive limb issubject to the negative limb. If you satisfy the positive limb, the conditions of thesubsection will only be met if you do not fail under the negative limb.

In the ordinary circumstances where an issuer has an unfettered option to convertconvertible notes into ordinary shares, but chooses not to do so, it seems that the onlylikely reason for this is the issuer's willingness to continue to allow the convertible notes toexist and, therefore, the issuer's willingness to continue to pay the coupons under thenotes. Accordingly, it can be said that where an issuer has the option to convertconvertible notes into ordinary shares, but chooses not to do so, the issuer's obligation to

24 For example, because it is not substantially more likely than not that the coupon payments from 2005 to 2011 will be atleast equal to the issue price of the convertible notes 25 For example, because it is substantially more likely than not that the coupon payments from 2005 to 2011 will at leastequal the issue price of the convertible notes.

mafm M0111800265v1 150630 21.12.2005 Page 16

pay interest remains non-contingent as the only event, condition or situation affecting theissuer is its willingness to meet the relevant obligation.

If this interpretation is correct, then in the above example 17 November 2014 would be thetime when the issuer's obligation to pay interest would no longer be non-contingent. Thatis, at the time the convertible notes were actually converted into ordinary shares. This viewis clearly consistent with the commercial objectives and features of the convertible notes. Itis also consistent with sub-section 974-100(1), which provides that if a debt interest is aninterest that will or may convert into an equity interest, the conversion is taken, for thepurposes of this Division, to give rise to a new interest (and is not merely treated as acontinuation of the debt interest).

In contrast, it appears that the approach adopted in the Draft Taxation Determinationoverlooks the negative limb in sub-section 974-135(3). That is, it fails to take into accountthe 'willingness' exception.

If the 'willingness' exception is not operative here to ignore the possibility of the issuerexercising the option to convert the notes, then the question is what the willingnessexception is intended to cover. Of course, all contractual obligations are ultimatelycontingent on the obligor's willingness to perform such obligations. Is the scope of the'willingness' exception limited to an issuer's willingness to comply with its contractualobligations under the relevant instrument? That would seem to be an absurdly limited viewof the exception, and contrary to subsection 974-135(1) and section 974-10 which direct usto consider matters of substance having regard to pricing, terms and conditions.

It must be acknowledged that the outcome of the Commissioner's view in the Draft TaxDetermination would be an appropriate outcome if the terms of issue of the notes requiredthe issuer to pay a punitive coupon rate in the period after the date on which the issuerbecame entitled to exercise the option (for example if there were to be a substantial step-up in the coupon after 17 November 2011). However, it is unfortunate that the Draft TaxDetermination is silent on whether it is directed at situations in which the issuer would besubject to a punitive coupon rate and so would be 'economically motivated' to exercise theoption.

However, even if it is accepted that it is appropriate to ignore the obligation to pay couponsafter a step-up, it would remain necessary to deal with the role of the 'willingness'exception. That is, if we accept that the appropriate treatment is to ignore the couponpayments after the date on which the stepped-up coupon is effective (ie, after17 November 2011), then we are really saying that the virtual certainty of the issuerexercising the option means that in substance the obligation to pay coupons after17 November 2011 can be ignored for the purposes of applying the debt test. Thisoutcome of ignoring the obligation to pay coupons should be achieved by the followingwords in the definition of 'effectively non-contingent obligation' in section 974-135(1):

there is in substance or effect a non-contingent obligation

However, even then the reason why we say that in substance the obligation can be ignoredin the period after the step up is because it is virtually certain that any issuer will not bewilling to pay the higher coupons. Hence, it is still necessary to reconcile this appropriateoutcome with the role of the 'willingness' exception.

mafm M0111800265v1 150630 21.12.2005 Page 17

It may be argued that this outcome of ignoring the obligation to pay coupons after the step-up might be achieved by section 974-40(3), which provides (albeit in the context of valuingthe effectively non-contingent obligations) that if the issuer:

… does have an effectively non-contingent obligation to exercise the right or option,the life of the interest ends at the earliest time at which the [issuer] will have toexercise the right or option. [Our emphasis.]

The difficulty with using section 974-40(3) as the basis for ignoring the coupons after thestep-up is that the phrase 'effectively non-contingent obligation' is then defined in section974-135 by reference to whether there is in substance or effect a non-contingentobligation. The word obligation has a legal meaning which is usually associated with alegally enforceable obligation such as a contractual obligation. Although the issuer is'economically motivated' to exercise the option at the time of the step-up, if what the issuerholds truly is an option then it could not be said that the issuer had an effectively non-contingent obligation to do so.

5.2 Reclassify

In addition, if the convertible notes were to satisfy the debt test in the period up to the timethat the issuer could exercise the option (ie, from 2011), it is unclear which provision wouldbe operative to 'reclassify' the notes as equity from that time.

One view would be that the notes effectively default to equity interests under section 974-55(1)(e), on the basis that there would no longer be a debt interest on issue.

The other view would be that there is a reclassification on the basis that there is a materialchange to the scheme. According to section 974-110:

(a) where a scheme gives rise to a debt interest (or an equity interest) in a companyand;

(b) the scheme subsequently changes, resulting in an equity interest (or a debtinterest) in the company coming into existence after the change;

Division 974 will apply after the change as if the scheme, as it existed immediately after thechange, came into existence when the change occurred.

If one considers the view adopted in the Draft Taxation Determination in light of section974-110, you would have to say that the Commissioner's view depends on the conclusionthat the material change occurs at the time when the option crystallises, rather than thetime when the convertible notes were actually converted into the ordinary shares. If this isso, you would have to query whether the Commissioner's interpretation would objectivelybe regarded by a court as the better view as it is questionable whether, in fact, there hasbeen a material change.

In light of the above, it will be interesting to see whether the Commissioner's view adoptedin the Draft Taxation Determination is ultimately maintained. We understand that the DraftTaxation Determination is to be converted into a tax ruling so that a more detailed analysisof the Commissioner's view and any alternative view is provided. A further related issuewill be whether the tax ruling will have retrospective application as the view currentlyadopted by the Commissioner in the Draft Taxation Determination is seen to represent aninterpretation that is inconsistent with previously stated views on this issue (see Example

mafm M0111800265v1 150630 21.12.2005 Page 18

2.26 contained in the Explanatory Memorandum to the New Business Tax System (Debtand Equity) Act 2001).

6. Solvency Clauses

Another issue relating to the meaning of effectively non-contingent obligation for thepurposes of section 974-135 is the effect of 'solvency clauses'. A 'solvency clause' isessentially a provision contained in certain debt documentation which sets out whathappens when the debtor is unable to pay the creditor. Solvency clauses can be drafted indifferent ways. However, regardless of its form, the effect and substance of such clausesis generally the same. That is, the debtor/issuer will not, in broad terms, be required tomake the relevant payments while the debtor/issuer is insolvent.

Up until the end of last month, the ATO and Treasury had expressed the view that, in somecases, the existence of a particular type of solvency clause may mean that thedebtor/issuer does not have an effectively non-contingent obligation to provide afinancial benefit on the basis that the issuer's obligation is contingent upon its solvency.

According to the National Tax Liaison Group Finance and Investment Sub-CommitteeMinutes of Meeting26, this issue first came to light after the Government announced inMarch 2003 that income tax regulations would be made to clarify the operation ofdebt/equity rules for certain Upper Tier 2 instruments issued Authorised Deposit-TakingInstitutions (ADIs)27.

In the course of developing those regulations, Treasury examined certain solvency clausesfound in Upper Tier 2 and Lower Tier 2 instruments. Treasury identified two types ofsolvency clauses. The first type was a clause which provides that where the obligationcould not be met, the issuer would become insolvent. The second type provides that, if theobligation to make the payment were required to be met and it would put the issuer intoinsolvency, the obligation to make the payment would not have to be met until such timethat the condition no longer applied.

It was the second type of clause that created the problems. In particular, the view wasexpressed by the ATO and Treasury that the obligation to make a payment could be seenas being contingent on the continuing solvency of the issuer and, therefore, contingent onthe economic performance of the entity having the obligation.

If this view were adopted, subordinated debt instruments containing these solvencyclauses would have failed to satisfy the debt test in Division 974, despite the fact that theseinstruments have been commonly understood to be debt. This would have had serious

26 see National Tax Liaison Group Finance and Investment Sub-Committee Minutes of Meeting of 11 August 2004,3 February 2005 and 8 August 200527 ADIs such as banks and building societies are required to keep a certain percentage of capital against their risk weightedassets. Capital is divided into three layers: Tier 1 which is pure equity (such as ordinary shares, non-redeemablepreference shares and certain hybrids), Upper Tier 2 which includes perpetual subordinated debt and Lower Tier 2 whichincludes fixed subordinated debt. These requirements are set out in Prudential Statements issued by the AustralianPrudential Regulation Authority (APRA). They are also the subject of a lucid discussion in Hill J's judgment in MacquarieFinance Limited v Commissioner of Taxation 2004 ATC 4866.

mafm M0111800265v1 150630 21.12.2005 Page 19

ramifications for the issuers of these instruments as, amongst other things, they wouldhave been unable claim deductions on the interest payments.

Fortunately, Treasury and the ATO now seem to have backed away from this view with theannouncement by the Minister For Revenue and the Assistant Treasurer on 25 October2005 that the Government would make new income tax regulations to ensure that 'solvencyclauses' do not preclude certain subordinated notes from being treated as debt for taxpurposes (Press Release No. 90 of 2005). Significantly, the press release states that,while these solvency clauses are commonly found in Lower Tier 2 term subordinated notesissued by ADIs, the regulations will apply to all issuers. No indication is given in the pressrelease as to when the regulations will be issued. However, it is stated that the regulationswill be developed in consultation with key stakeholders.

There can be little doubt that the position adopted by the Government in the 25 Octoberpress release represents the correct view. An obligation will be considered non-contingentif it is not contingent on any event, condition or situation (including the economicperformance of the entity having the obligation or a connected entity of that entity), otherthan the ability or willingness of that entity or connected entity to meet the obligation(sub-section 974-135(3)).

In the circumstances where an obligation to make a payment is dependent on the solvencyof the debtor, it is clear that the only relevant event, condition or situation affecting this willbe the debtor's ability to pay. This is reinforced by section 95A of the Corporations Act2001, which states that a person is solvent if, and only if, the person is able to pay all theperson's debts, as and when they become due and payable. Accordingly, it can be saidthat where an issuer's obligation to make a payment is made contractually contingent on itssolvency, the issuer's obligation to pay should remain non-contingent for the purposes ofsub-section 974-135(3) as the only event, condition or situation affecting the issuer is itsability to meet the relevant obligation.

In addition, in determining whether there is in substance or effect a non-contingentobligation, sub-section 974-135(6) provides that it is necessary to have regard to theartificiality or the contrived nature of any contingency on which the obligation to take theaction depends. According to paragraphs 2.178 and 2.179 of the ExplanatoryMemorandum to the New Business Tax System (Debt and Equity) Act 2001):

… where a contingency is so remote as to be effectively inoperative (immateriallyremote), it is as if the contingency did not exist and should be disregarded.

In some circumstances it will be clear that a particular contingency is immateriallyremote for these purposes. These will be cases where there is only a theoreticalrather than a real possibility of the contingency occurring.

Given that the debt and equity tests are to be applied at the time the relevant interestcomes into existence (and therefore, it is at that time that it is necessary to consider thelikelihood of any contingency occurring), it may be said that, where a financial institution orcorporate issues a debt instrument, the likelihood of that issuer becoming insolvent, will, inmost circumstances, be only a theoretical possibility and therefore, should be disregardedfor the purpose of section 974-135.

mafm M0111800265v1 150630 21.12.2005 Page 20

The final point to note is that, even if an issuer does becomes insolvent, it does notnecessarily mean that the issuer's obligation to make the relevant payments will not beperformed. Rather, the obligations of the issuer may be deferred until such time as theissuer is in a position to satisfy the obligations. The deferral of the issuer's obligations inthe event of insolvency is a common feature of the Upper Tier 2 and Lower Tier 2subordinated debt instruments Treasury examined. In addition, it must be rememberedthat if the issuer is wound up, the holders of the relevant instrument will have the right toclaim for amounts outstanding ahead of equity holders but behind more senior creditors.Therefore, in the circumstances where an issuer does become insolvent, the likelihood ofan issuer not being able to fulfil its obligations must really be considered on a case by casebasis.

7. Section 974-80

Section 974-80 provides an additional equity test. That is, the primary equity test is set outin section 974-75. However, in addition to the arrangements covered by section 974-75,an arrangement will be classified as equity if it satisfies the criteria of section 974-80.

7.1 Conceptual

In conceptual terms, the purpose of the equity test in section 974-80 is to cause a non-equity interest to be classified as equity if the non-equity interest is held by a connectedentity of the issuer, and the non-equity interest funds an equity-like return to a third person(that is, a return which has the hallmarks of equity under the primary equity test).

In colloquial terms, section 974-80 is directed at arrangements under which a 'debt piece' isissued to a connected entity and is used to fund an 'equity piece' held by a third person.The effect of section 974-80 is to cause the debt piece to be classified as equity.

Hence, section 974-80 can be viewed as a response to a concern on the part of therevenue that, by simply inserting an entity in between an issuer and an investor, companiescould achieve an outcome whereby the issuer obtains the tax benefits of issuing debt inrelation to a financing arrangement which, when viewed in its entirety, is equity in nature.

However, in the broader context, it is not clear why the tax laws should operate torecharacterise the debt piece as equity in these circumstances. In the absence ofcontrivance, why should it be a concern for revenue authorities if parties choose equityfunding at one level and debt funding at another level of an overall commercial transaction,particularly if the overall transaction is contained within the Australian tax system?

7.2 Limbs of Section 974-80

In broad terms the limbs of section 974-80 are as follows:

Issuer Connectedentity

Investordebt equity

mafm M0111800265v1 150630 21.12.2005 Page 21

the Debt Limb

Where:

(a) there is an interest issued by a company, and the interest:

(i) carries a right to a return;

(ii) is held by a connected entity of the issuer company;

(iii) is not an equity interest;

(iv) is a financing arrangement; and

(b) there is a scheme (or a series of schemes) designed to operate so that thereturn to the connected entity is to be used to fund (directly or indirectly) areturn to another person, called the ultimate recipient;

then the interest issued by the company will be an equity interest, if (c), (d) or (e) below aresatisfied:

the Equity Limb

(c) the return to the ultimate recipient is in substance or effect contingent on theeconomic performance of the company or a connected entity; or

(d) the return to the ultimate recipient is at the discretion of the company or aconnected entity; or

(e) the interest held by the ultimate recipient (or another interest arising from theschemes) gives the ultimate recipient (or a connected entity) a right to be issuedwith an equity interest in the company or a connected entity, or it will or mayconvert into an equity interest in the company or a connected entity,

unless the interest forms part of a larger interest that is characterised as a debt interest inthe company or a connected entity.

7.3 The Equity Limb

It is noted that the 'equity limb' above will be satisfied if the return to the ultimate recipient iscontingent on the performance or discretion of the issuer company or a connected entity,or if the ultimate recipient broadly has a right to be issued with an equity interest in theissuer company or a connected entity.

As section 974-80 has the potential to apply where a connected entity of the issuer of thedebt piece has issued an equity-like instrument the ultimate recipient, and as the 'equitylimb' can be satisfied by there being an equity-like relationship between the ultimaterecipient and a connected entity, the 'equity limb' of section 974-80 will often be easilysatisfied once it has been established that the issuer of the equity piece is a connectedentity of the issuer of the debt piece.

In a conceptual sense it is suggested that this represents a flaw in the design of section974-80. It is suggested that section 974-80 should only be operative where there is anequity-like relationship between the issuer of the debt piece and the ultimate recipients.That is, where in substance the underlying issuer has issued equity to the ultimate recipient

mafm M0111800265v1 150630 21.12.2005 Page 22

but where a connected entity has been interposed between the ultimate recipients so as togive the underlying issuer the tax benefits of having issued debt.

Unfortunately, the terms of section 974-80 are much broader. The terms of section 974-80provide that the 'equity limb' can be satisfied by the existence of an equity-like relationshipbetween the connected entity and the ultimate recipients, and for this reason the 'equitylimb' will often be easily satisfied.

7.4 Designed to Operate

It follows from the conclusion stated in 7.3 that the main focus in the interpretation ofsection 974-80 will be the 'debt limb'. In particular, the main focus will be on whether thereis a scheme designed to operate so that the return on the debt piece is used to fundthe return on the equity piece. In this respect it is possible to make the followingobservations.

(a) It is necessary and appropriate to give the words 'designated to operate' somemeaningful role. That is, section 974-80 should only apply where it is clear that thearrangement was 'designed' or 'put together' on the basis that the debt piece wouldbe used to fund the equity piece. This must manifestly be a design feature of thearrangement.

Section 974-80 would not apply where it is merely a factual coincidence that thecash flows from the debt piece would logically or conveniently be used to fund theequity piece.

Further, it is suggested that section 974-80 should only apply where there is clearevidence to show that the parties intended to 'design' or 'put together' thearrangement in this way.

(b) The proposition in (a) is evident from the history of section 974-80. When the NewBusiness Tax System (Debt and Equity) Bill 2001 was first introduced intoParliament, subsection 974-80(1)(d) merely referred to 'a scheme under which' thereturn on the debt piece 'is to fund' the return on the equity piece. As a result ofamendments to this subsection moved by the Government in the Senate, thewords 'designed to operate' were inserted into subsection 974-80(1)(d). In relationto this amendment, the Supplementary Explanatory Memorandum and Correctionto the Explanatory Memorandum to the Bill states, at para 1.29:

1.29 This means, generally speaking, that section 974-80 would not applyunless there is a plan constituted by documented rights and obligationsthat provide for the direct or indirect funding of a return to the ultimaterecipient. A lack of documentation would not preclude the application of theprovision if the design was clear from the surrounding facts andcircumstances. However, mere association between the parties would notbe a sufficient indicator of the relevant design. [Our emphasis]

(c) One might consider a scenario under which Shareholder A subscribes $200 tofixed dividend preference shares in Connected Entity Co and the othershareholders subscribe $100 to ordinary shares in Connected Entity Co, and thenConnected Entity Co makes a $300 loan to Issuer Co. Connected Entity Co willreceive interest income on the $300 loan and, subject to the discretion of its

mafm M0111800265v1 150630 21.12.2005 Page 23

directors and available profits, it will pay dividends to its shareholders. The termsof the preference shares mean that Connected Entity Co would apply the interestincome on the $300 loan to pay the preference dividends before any dividendswere paid on the ordinary shares.

Could it be said that there is a scheme designed to operate so that the return onthe $300 loan is used to fund the fixed dividends on the preference shares? It issuggested that the answer is no unless there is evidence of a plan constituted bydocumented rights and obligations under which Connected Entity Co is requiredto apply the interest income or redemption proceeds from the $300 loan to pay thefixed dividends on the preference shares or a redemption of the preference shares.It is suggested that, in the absence of such evidence, then it is merely a factualcoincidence that the return on the $300 loan would logically and conveniently beused to fund the return on the preference shares.

The fact that the Supplementary Explanatory Memorandum refers to 'documentedrights and obligations' indicates that this test will be satisfied if Connected Entity Cowere to be subject to a contractual obligation to apply the return on the $300 loanto fund the preference shares. It is suggested that the test will not be satisfied ifthere is nothing more than an expectation that this would logically be the case butwhere there is also no restriction on Connected Entity Co using or procuring otherfunds to fund the return on the preference shares.

(d) There is limited guidance from the courts on how to interpret the phrase 'designedto operate'. In the context of sales tax, the comments of the Federal Court inSondo Pty Ltd v FCT28 indicate that it will be most relevant to consider the intrinsiccharacteristics of the arrangement and the intention of the parties in putting thearrangement together.

It is suggested that the recent Full Federal Court decision in Macquarie FinanceLimited v Commissioner of Taxation29 is instructive on the question of when a courtmight find that a return on a debt piece is 'designed to operate' so as to fund areturn on an equity piece. In this case the court considered a transaction structureunder which notes issued by Macquarie Finance Limited would pay 'interest' tonoteholders until such time as certain 're-direction events' occurred which requiredit to pay 'interest' to Macquarie Bank Ltd (and not to the noteholders). If those re-direction events occurred, dividends would then be paid by Macquarie Bank Ltd onthe preference shares held by the noteholders (the preference shares were'stapled' to the notes). It seems from the judgment in this case that the court wasof the view that if the re-direction events occurred, then the 'interest' payments onthe notes and any redemption of the notes would be used by Macquarie Bank Ltdto fund the dividend payments on the preference shares. For example, atparagraph 174, Hely J states:

28 91 ATC 4203, at 421229 [2005] FCAFC 205.

mafm M0111800265v1 150630 21.12.2005 Page 24

Once a Payment Direction Event occurs, the proceeds of the notes issuewould become available to MBL to fund its obligations under the preferenceshares.

7.5 Third Party Finance

As noted above, it seems that the 'equity limb' will often be easily satisfied when theultimate recipient is receiving an equity-like return from a connected entity of the underlyingissuer.

However this will not be the case when the relevant ultimate recipient is receiving a debt-like return. In particular, the equity limb should not be satisfied merely because a thirdparty bank provides finance to an entity that is a connected entity of a company, eg section974-80 should not apply merely because a third party bank provides finance to a jointventure vehicle which is a connected entity of its own parent joint venturers. In the 'equitylimb' the 'contingent on economic performance' element is defined to exclude the ability orwillingness to pay (section 974-85). Hence, provided the finance provided by the thirdparty bank is not expressed to be linked to the performance of the joint venture vehicle orthe parent joint venturers (eg, is not linked to profit, dividends, net cash etc), then thefinance provided by the bank of itself should not cause section 974-80 to apply.

This line of analysis would of course cease to hold if the terms of the financing resulted inthe banks having an equity-like exposure to the structure. For example, if the third partybank held an option or similar security interest over the shares in the joint venture vehicle.

This scenario may be represented as follows. However, even if the third party bank wereto have an equity-like exposure, the 'designed to operate' test would still need to besatisfied.

Another area of concern in relation to funding generally will arise when loans are made tocompanies which are connected entities of the lender.

Section 974-80 can apply where the holder of the debt piece is a 'connected entity' of itsissuer. A 'connected entity' is defined in section 995-1 to be:

Bank A B

JV Co(connected entity)

Loan

Option over shares in JV Co granted to Bank

Loan

mafm M0111800265v1 150630 21.12.2005 Page 25

(a) an 'associate' of the issuer company, as defined in section 318 of the Income TaxAssessment Act 1936; and

(b) another member of the same 'wholly owned group' as defined in sections 975-500and 975-505.

The section 318 definition of associate will capture the scenario where the issuer of thedebt piece is 'sufficiently influenced' by the holder of the debt piece. As such, the followingstructure may create a concern under section 974-80. However, as noted above, section974-80 would only apply if it was clear that the loan to C was designed to operate to fundreturns on the shares in A.

The definition of associate in section 318 also captures a trustee of a trust, where theissuer of the debt piece, or an associate of the issuer of the debt piece, benefits under thetrust. As a controller of the issuer of the debt piece would clearly be an associate of thatissuer, section 974-80 may be a concern in the following structure if a controller ofCompany A benefits under the trust.

Unit Trust Company A

Units Shares

Stapled

Assetloan

A B

C

Ultimate Recipient

Loan

Shares

60% 40%

mafm M0111800265v1 150630 21.12.2005 Page 26

7.6 Another Person

Section 974-80 will only apply if there is a scheme designed to operate so that the returnon the debt piece is to be used to fund a return to another person, being the ultimaterecipient (subsection 974-80(1)(d)).

The words of subsection 974-80(1) indicate that the section will only apply where theultimate recipient is a person other than the issuer company and the connected entity.This therefore indicates that section 974-80 will not apply where the ultimate recipient is thesame person as the issuer company by operation of the Single Entity Rule contained insection 701-1.

Hence it seems that section 974-80 should not apply to the following structure.

However, it must then be asked whether section 974-80 would apply if a third party held anequity interest in the connected entity.

7.7 Apportionment

It is important to note that the effect of section 974-80 is to reclassify the debt piece as anequity interest. The terms of section 974-80 do not expressly provide for apportionment ifonly part of the return on the debt piece is designed to fund a return on the relevant equitypiece held by the ultimate recipient. This suggests that the entire $205 debt interest heldby the connected entity below may potentially be reclassified as an equity interest undersection 974-80.

SM 1

HC

SM 2

ConnectedEntity

Debtinterest

Equityinterest

Connectedentity

UltimateRecipient

Issuer

$205 Loan

$200 Loan

$5 contingent loan,or equity

ma

• s.975.150 scheme is broadly defined per s.995-1; Commissioner can dissect a scheme into unrelatedschemes.

• s.975-155 related schemes are stapled, inter-dependent, complimentary.↓

• s.974-130 a financing arrangement is entered into to raise finance; does not include derivatives, genuineleases and royalties, securities lending.

↓

The debt test is satisfied if:1. an entity receives a financial benefit;2. the entity has an effectively non-contingent obligation to provide a financial benefit; and3. is substantially more likely than not that the value of the benefit provided will at least equal value of benefit received.

Exception: trade credit of 100 days or less (s.974-25).

↓

The1. 2.

3.

Lim

There must be a scheme, or two or more related schemes

There must be a financing arrangement (unless it is a share)

Is there a debt interest? A debt interest can arise in three situations

1. Where a scheme satisfies thedebt test when it comes intoexistence (s.974-15(1) )

2. Where two or more related schemeshave the combined effect of satisfyingthe debt test, and this is intended(s.974-15(2) )

3. Where a scheme satisfies the debttest because the sum of the non-contingent and other benefits providedat least equal the benefits received,and the Commissioner so determines(s.974-65)

The debt test (s.974-20)

Note: If there is a debt interest, deductions for returns on the debt interest may be modified and/or limited by the ‘deductions forhybrids’ provision: s.25-85.

↓

Is there an equity interest? An equity interest can arise in 3 situations, unless the scheme also satisfies the debt test, or it formspart of a larger interest which satisfies the debt test.

3. Where a non-equity interestcarries a right to a

1. Where a scheme satisfies theequity test when it comes intoexistence (s.974-70(1) )

fm M0111800265v1 150630 21.12.2005

equity test is satisfied if:the interest is a share in a company;the right to a return or the amount of the return

• in substance or effect contingent on eco

• at the discretion of the company; orthe interest:

• gives the holder a right to be issued with

• will or may convert into an equity intereited exception: 'at call loans. (s.974-75(4) ).

2. Where 2 or more related schemes have thecombined effect of satisfying the equity test, andthis is intended (s.974-70(2) )

return from aconnected entity andis to be used to funda return to the)

The equity test (s.974-75

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on the interest is:

nomic performance; or

an equity interest; or

st.

ultimate recipient,and the return to theultimate recipient iscontingent oneconomicperformance ordiscretion, or theultimate recipient’sinterest will or mayconvert to equity(s.974-80)

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