Affairs of capital in the land of corporates (for SME’s)

Presented at the QLD Tax Forum on 29 – 30 May 2024

At its broadest level, funding private groups and investments involves:

  • the ‘funding’ itself – which is most often cash but can, alternatively, be the services of key people (‘human capital’) or the contribution of existing assets (e.g. premises or existing intellectual property) by immediate transfer or by allowing the use of assets (e.g. by lease or licence);
  • the chosen entity (company, trust of partnership) as the vehicle for the relevant business or investment activity being funded – here, the focus is on funding companies;
  • contribution of the funding into the chosen entity in a manner that results in acquiring a particular ‘interest’ in the entity – which can be such interests as shares, options, loans or other contractual rights; and
  • receipt of a return for the funding from the interest acquired – which can be a fixed or variable return and be in the nature of dividends, loan interest, salary or bonus or other contractual returns, depending on the form of interest acquired.

Because private groups often source their funding from related parties (often family members) or from amongst a small group of ‘closely co-ordinating’ owners/investors, there are often greater opportunities to implement more flexible funding arrangements – e.g. recognising variable contributions for variable returns, making non-monetary contributions for no immediate payment, making at-call loans.

These types of funding arrangements often seek to provide the ‘funding’ in a manner that provides flexibility around matters such as (not exhaustively):

  • timing or certainty of repayment – e.g. at call loans with nil or a variable/profit-based interest rate;
  • the ability to both be repaid funds provided and to share in future ‘super’ profits and capital gains – e.g. loans with an attached ability to take up equity (such as convertible notes, options to take up equity), redeemable shares, contractual loan terms with variable/profit-based returns; and
  • matching returns payable to different initial or ongoing contributions made – e.g. different share classes with variable dividend and capital entitlements based on agreed formulas (per the constitution, a shareholders’ agreement or otherwise).

In pursuing flexibility, these funding arrangements often seek to blend the usual legal characteristics of debt, equity or contractual ‘interests’ and their associated ‘returns’.

But, in doing so, these flexible arrangements require an awareness of, and careful management under, various taxation provisions to avoid potentially unfavourable tax outcomes.

This paper seeks to provide an overview of the typical taxation complexities and issues that need to be navigated when private groups seek to implement funding arrangements for their business or investment activities, especially flexible and innovative arrangements between related or closely co-ordinating parties.

The paper proceeds by examining the types of issues that typically require attention under the following headings/provisions:

  • Capital gain tax (CGT) and income tax basics (including deemed market value, cost base and alienation of income issues)
  • Value shifting rules (including on the issue of variable return interests)
  • Debt/equity rules (including related party financing, at-call loans)
  • Employee share schemes
  • Franking credit issues that can affect equity raisings
  • Thin capitalisation considerations for SMEs
  • Anti-avoidance matters

References to sections in this paper are generally to the Income Tax Assessment Act 1997 (ITAA97), unless otherwise stated. Other legislation referred to includes the Income Tax Assessment Act 1936 (ITAA36).

The Taxation of Financial Arrangement (TOFA) rules in Division 230 are beyond the scope of this paper – but, in any case, would not be applicable to most private groups due to the size and turnover thresholds (e.g. $100 million turnover, $300 million assets) below which the TOFA rules do not apply (except for the qualifying security rules mentioned below).

Capital gains (and some income) tax basics

It is relevant to first recall some ‘basics’ when it comes to flexible funding arrangements, before moving onto some applicable specialist provisions.

Shares for nil/normal/discounted price or for a premium

When creating interests (shares or loans) in a company or creating contractual rights (e.g. profit share arrangements, rights for payment for leased/licenced assets) as part of funding (by cash, labour or assets) of the company, the analysis should include the general CGT and income tax effects before moving onto the more specialised tax provisions that may apply.

In particular, the operation of section 112-20 is relevant:

112-20   Market value substitution rule

(1)      The first element of your *cost base and *reduced cost base of a *CGT asset you *acquire from another entity is its *market value (at the time of acquisition) if:

(a)      you did not incur expenditure to acquire it, except where your acquisition of the asset resulted from: 

i.        *CGT event D1 happening; or

ii.       another entity doing something that did not constitute a CGT event happening; or 

(b)      some or all of the expenditure you incurred to acquire it cannot be valued; or

(c)      you did not deal at arm’s length with the other entity in connection with the acquisition. The expenditure can include giving property: see section 103-5.

(2)      Despite paragraph (1)(c), if:

(a)      you did not deal at arm’s length with the other entity; and

(b)      your *acquisition of the *CGT asset resulted from another entity doing something that did not constitute a CGT event happening;

the *market value is substituted only if what you paid to acquire the CGT asset was more than its market value (at the time of acquisition). The payment can include giving property: see section 103-5. [Emphasis added]

Issuing shares for nil or nominal consideration may occur where the incoming shareholder is providing input/funding that does not have an immediate or proven value, but where a company with existing cash or other tangible assets sees that input/funding as valuable. The company may then, quite reasonably, be prepared to secure that funding by issuing shares at a low cost that provided access to the existing company value and future profits/gains of the company.

The incoming shareholder may, for example, be providing:

  • certain credibility that may attract other investors, by being known to be on the share register;
  • ideas or intellectual property (IP) that is currently very uncertain in value – so there is no current market and its range of possible values is meaningless until further work is done (and the incoming shareholder does not want to formally recognise, by agreement, a current value on which they would be taxed); or
  • access to desired personal skills.

The basic CGT deemed cost base rules work in a way that any discount provided on the issue of shares, does not provide an adjustment upwards to a market value cost base

If there is no consideration, the table in section 112-20(3) – by items 4 and 5 – excludes the application of section 112-20(1) and any deemed market value cost base, for the grant of rights to acquire shares, or options to acquire shares, in a company (item 4) and the acquisition of shares in a company (item 5) where nothing is paid

Section 112-20(2), as bolded above, then has the effect of excluding any deemed market value cost base where less than market value is paid under a non-arm’s length dealing – because the issue of a share does not represent a CGT event (disposal ) by the company (see exclusion from CGT event D1 under section 104-35(5)(c)) and the market value substitution only applies where more than market value is paid

For example, if company X is worth $100 and an incoming shareholder is allowed to only give $1 for 50% equity, then the incoming shareholder has received a discount. But the cost base of that transaction is not adjusted up for the incoming shareholder if not dealing at arm’s length

That ‘non-adjustment’ does not cause an immediate disadvantage to the incoming shareholder – but does mean the shareholder should remain aware they will be subject to future tax on the basis of their nil/nominal cost base

The other shareholders do not retain the advantage of a higher cost base as these circumstances will fall within the value shifting rules discussed below – so that their CGT cost bases will be adjusted downwards.

In summary, in these ‘issued at a discount’ circumstances the tax rules remove any advantage.

Alternatively, shares may be issued for a premium where the situation is reversed – e.g. where the incoming shareholder is providing the cash for a company which already holds ideas or IP of uncertain value.

In these circumstances, the basic CGT deemed cost base rules work in a way that any premium provided on the issue of shares, does cause an adjustment downwards to a market value cost base.

Specifically, section 112-20(2) as bolded above, has this effect because the issue of a share does not represent a CGT event (disposal ) by the company (again, see exclusion from CGT event D1 under section 104-35(5)(c)) and the market value substitution does apply where more than market value is paid – to reduce the cost base.

For example, if company X requires capital and an incoming shareholder is willing to give $100 for 50% equity, then commercially speaking, company X could be expected to be worth $200 in total and $100 before the extra $100 share subscription. If instead, company X is in fact worth only $50 based on the market value but with a potential future value for which the incoming shareholder is prepared to still pay the $100 for 50%, then the cost base of that transaction is adjusted down for the incoming shareholder if not dealing at arm’s length because they invested more than the market value of the equity received.

That ‘non-adjustment’ does cause an immediate disadvantage – as it means:

  • the incoming shareholder will have their cost base reduced and may pay tax in future on their share of the actual value they contributed; and
  • the other shareholder may also pay tax in the future on their share of the actual value contributed by the incoming shareholder, as their cost bases are not increased under the value shifting rules discussed below.

In summary, taxpayers must look after themselves and are left to suffer the disadvantage when they pay more than they should in a non-arm’s length situation.

Giving of property – market value

Section 103-5 causes property given to be valued at market value and for that value to be counted as proceeds or costs for CGT purposes:

103-5     Giving property as part of a transaction

There are a number of provisions in this Part and Part 3-3 that say that a payment, cost or expenditure can include giving property.

To the extent that such a provision does say that a payment, cost or expenditure can include giving property, use the *market value of the property in working out the amount of the payment, cost or expenditure

Accordingly, IP or other assets given to acquire shares or other rights must be valued and counted at that value.

The ATO’s guidelines on market value will need to be considered where non-cash consideration is provided:

https://www.ato.gov.au/General/Capital-gains-tax/In-detail/Market-valuations/Market-valuation-for-tax-purposes

But, as already mentioned above, valuing some assets can be very difficult – especially when those assets are unproven (e.g. unproven IP) so that there is no existing market. A valuation exercise seeking to predict possible future cash flows and incorporate weightings for uncertainty can result in a meaningless ‘average’ value, between binary outcomes of success (high value) or failure (no value).

These difficulties can drive the different forms of funding arrangements, by seeking to preserve access to future success (through future access to profits/gains) without payment of some ‘standard’ up-front and uncertainly valued contribution.

Even where it may be possible to come to some sensible range of possible market values, there will often be a tension between the desire to recognise/maximise an up-front value financially – on which value the percentage of shares or other interests may be based – versus the tax/CGT on contribution/transfer of the asset to the company as the funding.

Each situation will need to be considered on its own facts.

Granting of rights

Where funding is provided through the use of an asset (e.g. by lease, licence), rather than by transfer to the company, the tax implications of granting the lease, licence or other rights will need consideration.

Section 104-35 and CGT event D1 is relevant:

104-35 Creating contractual or other rights: CGT event D1

(1)      CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity.

Example: You enter into a contract with the purchaser of your business not to operate a similar business in the same town. The contract states that $20,000 was paid for this.  You have created a contractual right in favour of the purchaser. If you breach the contract, the purchaser can enforce that right. 

(2)     The time of the event is when you enter into the contract or create the other right.

(3)      You make a capital gain if the *capital proceeds from creating the right are more than the *incidental costs you incurred that relate to the event. You make a capital loss if those capital proceeds are less.

(4)      The costs can include giving property: see section 103-5. However, they do not include an amount you have received as *recoupment of them and that is not included in your assessable income, or an amount to the extent that you have deducted or can deduct it.

Exceptions

(5)      CGT event D1 does not happen if: 

(a)      you created the right by borrowing money or obtaining credit from another entity; or

(b)      the right requires you to do something that is another *CGT event that happens to you; or 

(c)      a company issues or allots *equity interests or *non-equity shares in the company; or

(d)      the trustee of a unit trust issues units in the trust; or 

(e)      a company grants an option to acquire equity interests, non-equity shares or *debentures in the company; or

(f)      the trustee of a unit trust grants an option to acquire units or debentures in the trust.

Example: You agree to sell land. You have created a contractual right in the buyer to enforce completion of the transaction. The sale results in you disposing of the land, an example of CGT event A1. This means that CGT event D1 does not happen. [Emphasis added]

There is no deemed market value capital proceeds for CGT event D1 where there are no actual capital proceeds per section 116-30(3)(b) – but, equally, there is no deemed market value cost base in these circumstances per the table in section 112-20(3) item 3.

There can be both an increased or decreased deemed market value for capital proceeds and deemed market value for the cost base for CGT event D1 in a non-arm’s length dealing, where some payment is made.

There are also the specific provisions dealing with the grant/variation of leases (e.g. CGT event F1 for grant).

The point is that, for funding arrangements that take the form of contractual rights other than shares or loans, CGT implications arise – and that there are some special rules about deemed market value cost bases or proceeds to take into account when structuring those arrangements.

Alienation of income

Remember there are also specific provisions in Division 6A ITAA36 relating to the alienation of income.

Though we tend not to have to look at those provisions these days, that is because the provisions have essentially rendered ineffective most attempts to alienate income separately from selling the underlying asset. Also, there is the effect of the ‘second strand’ of reasoning in the High Court’s reasoning in FC of T v Myer Emporium Ltd 87 ATC 4363 – that a lump sum received in substitution for the value of future income (interest in Myer Emporium) is assessable income.

These provisions and Myer Emporium are mentioned here because they may need to be considered in respect of possible profit-sharing arrangements proposed to be entered into as part of funding arrangements outside of shares or loans. Funding provided by way of a payment for acquiring those rights will typically be assessable.

It is important to bear in mind the distinction between such assignment of the income stream (e.g. interest, royalties, dividends) and the assignment of the underlying asset itself – such as happens, under Australian law, when an Everett assignment is done. But, of course, assigning the asset itself has its own tax consequences.

Section 102B causes the transfer of rights to income to be ignored for tax when the transfer is to an associate of the transferor, for less than 7 years and not for arm’s length consideration.

Section 102CA causes any (actual) consideration received for the transfer of rights to income to be assessable income when (generally, section 102B does not apply and) the transfer is to any person for any term.

(There are certain exceptions to the specific provisions not relevant here, including for transfers under a will, maintenance payments and if Division 230, TOFA, applies.)

An example where these issues were considered is SP investments Pty Limited (as Trustee of the LM Brennan Trust) v FCT 93 ATC 4170, where an assignment of part of a royalties stream for longer than 7 years was made for a lump sum held assessable, under the reasoning in Myer Emporium.

While such alienation of income is obviously a form of disposal of an asset (which taxpayers would pre Myer Emporium seek to be of a capital nature), it is also a form of funding in that, in substance, a share of an income stream from a business is being provided for a payment.

An example of an arrangement of this type encountered in practice is funding provided by an ‘employee’ of a franchised business, under a document purporting to be in the legal form of a loan but where the (any) return is an agreed share of the borrower’s profit and a share of the proceeds on later sale of the borrower’s business. (In the particular example in mind, the borrower was a trust. The debt equity rules, discussed below, would also need to be considered for a company.)

Qualifying (deferred interest) securities

It is not intended to discuss in detail the rules for qualifying securities in Division 16E of the ITAA36 – but it is important to remember that these rules will apply to private groups regardless of the TOFA thresholds.

There may be forms of funding by way of loans (alone or combined with other contractual arrangements) on which a return is structured other than by way of traditional periodic interest – by deferral or variability (maybe profit based?) of the return – for which these rules need to be considered.

The scope of ‘security’ to which these rules can apply is very wide. Per section 159GP(1) of the ITAA36 security is defined to include:

(a)      stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;

(b)      a deposit at bank or other financial institution;

(c)      a secured or unsecured loan; or

(d)      any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured.

But the ATO accepts (see TD 2008/21 paragraph 20) that:

… having regard to paragraphs (a), (b) and (c) of the definition of ‘security’, in subsection 159GP(1) of the ITAA 1936 only those contracts that have debt like obligations will usually fall under paragraph (d) of the definition of ‘security’.

A profit-based return will likely not be within the rules, as it would give rise to issues around whether:

  • the arrangements are a debt like obligation – so as to be a ‘security’ subject to the rules; and
  • whether the profit-based return could be an ‘eligible return’ necessary for the rules to operate – as the ‘reasonably likely’ threshold for such a return could not be satisfied (see comments in ATO ID 2008/42 – though now withdrawn)

The possibility of these provisions applying would need to, at least, be considered in respect of variations of the type of arrangement referred to at the end of section 2.4 above; i.e. funding provided under a document purporting to be in the legal form of a long term loan and where the (any) return is variable – but which may be sufficiently certain to be an ‘eligible return’. For example, if the profit sharing from the borrower had some base accumulating ‘interest’ rate plus the variable upside, and that return is deferred (to seek to match in effect the position of an owner) to not be payable until actual cash profits of a certain amount had been received by the borrower.

Value shifting rules 

Overview

Before launching into relevant specifics of the general value shifting (GVS) regime/rules, it is useful to remember the overall scope of the rules.

The ATO’s Guide to General Value Shifting Regime (NAT 8366-2006 – dated 2006) (ATO Guide) is a detailed and useful guide to the rules – and some of that ATO Guide’s materials and examples are referred to below.

The GVS rules apply to three types of value shifts:

  • Direct value shifts from created rights (DVS Rights) – Division 723
  • Direct value shifts from entity interests (DVS) – Division 725
  • Indirect value shifts (IVS) – Division 727

The following flowchart from the ATO Guide provides a (highest level) summary of when the GVS rules need to be considered, including their applicable thresholds:

[ATO’s Guide to General Value Shifting Regime NAT 8366-2006]

This paper will not consider the IVS rules and the DVS Rights, although the (longer term) effects of those rules may need to also be considered in some funding situations because:

  • the IVS rules do not trigger immediate capital gains – they are directed to adjusting cost bases; and
  • the DVS Rights rules operate by reducing a loss that would otherwise be made upon (later) realisation of an underlying asset as a result of value having been shifted out of the asset through the creation of a right out of, or over, the asset. No reductions are made to the extent the value shifted has been taxed on the creation of the right (e.g. CGT event D1).

This paper focuses on the DVS rules, being the rules most likely to have immediate implications for proposed types of funding arrangements – as they will most directly address funding arrangements involving the issue or variation of shares with special rights or of loans with special rates of return.

The current DVS rules have been in place since 1 July 2002. Broadly:

  • DVS applies to debt (loan) interests as well as equity (share) interests – relevant for possible types of funding arrangements involving debt; and
  • DVS applies to ‘active participants’ holding interests in closely held entities, not just the controllers and their associates – relevant for possible types of funding arrangements between co-operating but not associated parties.

The following statement from the ATO Guide advises the steps by which taxpayers can ensure the GVS (including DVS) rules do not apply to them:

‘You can make sure the regime doesn’t apply by ensuring:

  • equity and loan interests in entities are issued at market value
  • rights over any underlying asset are granted for full market value consideration, and
  • entities provide economic benefits to each other at market value or otherwise deal at arm’s length.

While seemingly simple enough guidance, the demands of the providers of funding and different factual/valuation circumstances still commonly give rise to many circumstances when the GVS, including the DVS, rules need to be considered and managed.

Obviously, determining market values is a part of assessing any value shifts, so that issues and decisions around values for difficult or uncertain (e.g. unproven) assets arise here also, and reference to the ATO’s guidelines on market value will be appropriate (per the link above at section 2.2).

DVS rules

Key issue

There cannot be an (entity interest) DVS unless both of these ‘limbs’ arise:

  • there is a decrease in the market value of one or more equity or loan interests in a target entity (called down interests), and
  • there is an increase in the market value of one or more equity or loan interests, or the issue at a discount of one or more equity or loan interests in the same target entity (called up interests).

Diagrammatically, per the ATO Guide:

It is significant, however, that the decrease in value of the down interest does not include the issue of the interest at a premium – paying more than the interest’s value, so that the holder makes an immediate loss.

That loss of value is picked up by the general CGT rules to cause a reduction of cost base. But, as there is no DVS (the first limb is not satisfied), no upwards adjustment occurs for any up interest.

General DVS rules

For there to be a DVS, four conditions need to exist in respect of a relevant ‘target entity’ (per mainly section 725-50):

  • the control test is satisfied (section 725-55);
  • the participants in the scheme (cause of the value shift) test is satisfied (sections 725-65);
  • there are affected owners of interests in the target entity (sections 725-80 and 725-85); and
  • no exception applies (sections 725-70, 725-90 and 725-95).

The control test

The control test will be satisfied if an entity controls the target entity at some time during the period beginning when the scheme is entered into and ending when the scheme has been carried out.

The existence of just one controller during this period is sufficient to satisfy the control test, but there may be more than one controller during the period.

The participants in the scheme test

The participants in the scheme test looks at whether one or more of the following persons did the things under the scheme that the decreases or increases in value of interests, or issues at a discount, were reasonably attributable to:

  • the target entity itself;
  • a controller of the target entity;
  • an entity that is an associate of the controller at or after the time when the scheme was entered into; and
  • an active participant in the scheme.

Active participant

A participant can only be an active participant if:

  • at some time while the scheme was being carried out, the target entity was a closely held entity; and
  • the active participant owned either a down interest or an up interest in the target entity or had an up interest issued to it at a discount in the target entity.

Affected owners of interests in the target entity

As flagged at the start of this section, for there to be consequences for DVS there must be an affected owner or owners of:

  • at least one down interest in the target entity; and
  • at least one up interest in the target entity.

Affected owners of down interests

There will be an affected owner of a down interest in the target entity if one of the following entities owned the interest at the time it decreased in value under the scheme:

  • the controller of the target entity;
  • an entity that was an associate of the controller at or after the time when the scheme was entered into; and
  • an active participant in the scheme.

Affected owners of up interests

There will not be affected owners of up interests in a target entity unless there is at least one affected owner of a down interest.

There will then be an affected owner of an up interest in the target entity if one of the following entities owned the interest at the time it increased in value under the scheme or alternatively had an interest issued to it at a discount under the scheme:

  • the controller of the target entity;
  • an entity that was an associate of the controller at or after the time when the scheme was entered into;
  • an entity that was, at or after the time when the scheme was entered into, an associate of an entity that is an affected owner of a down interest because it was an associate of the controller; and
  • an active participant in the scheme.

The de minimis exception

Under the de minimis exception, there are no consequences for an entity interest direct value shift under a scheme if the sum of the decreases in market value of all equity and loan interests in the target entity because of DVSs under the scheme is less than $150,000 (section 725-70).

Where two or more DVSs happen under different schemes they may be considered together if it is reasonable to conclude that the sole or main reason for this was to access the benefit of the exception.

The reversal exception

Under the reversal exception, there are usually no consequences for an entity interest direct value shift under a scheme if it is more likely than not that, at the time the first of the things done under the scheme happens, the cause of the value shift will reverse within four years under the terms of the same scheme (sections 725-90 and 725-95).

Effect of DVS

Broadly, a direct value shift under a scheme between equity or loan interests in a company or trust gives rise to the following consequences for affected owners:

  • entities with equity or loan interests that decrease in value will be required to decrease the tax values (cost bases, carrying costs) of their interests and, in some cases, may make gains that are included in assessable income in the year in which the value shift happens, and
  • entities with equity or loan interests that increase in value, or that are issued at a discount, in relation to the same scheme will be required to increase the tax values of their interests.

Loans – at above or below market interest rates

Even something as seemingly simple as the interest rate on a loan to a company being set below or above market rates will require consideration of the DVS rules.

If a loan is provided at a below market (including nil) interest rate, the loan is being provided at a premium. The correct market (present) value of the loan will be less than its face value (the principal loan funds lent) because those loan funds will be repaid in the future without any/with less than market interest.

As already noted above, such a loan will be not be a down interest. Issue at a premium does not fall within the first limb for a DVS – even though there will be up interests because the equity interests in the company will be increased from the savings in interest that would apply as compared to the market rate.

For a loan, the CGT cost base reduction discussed above as arising under the general CGT rules, would not apply as the loan will not have been ‘acquired from another entity’ in the sense of the words at the start of section 112-20. (Also, the making of the loan itself is not a CGT event D1 per the exclusion in section 104-35(5)(a).)

But if a loan is provided at an above market interest rate, the loan is being provided at a discount. The correct market (present) value of the loan will be more than its face value (the principal loan funds lent) because those loan funds will be repaid in the future with above market interest.

Such a loan will be an up interest. Issue at a discount does fall within the second limb for a DVS – and there will be down interests because the equity interests in the company will be decreased from the extra interest that would apply as compared to the market rate. Accordingly, cost base adjustments may arise under the DVS rules if the other conditions are met.

Varying the rate of interest on an already existing loan can also give rise to DVS consequences – both where the interest rate is decreased or increased. There will be a decrease in market value of the (already existing) loan as a down interest under the first limb of a DVS where the interest rate is decreased versus the initial premium paid being ignored if the initial interest rate is below market (or nil).

Determining these potential DVS implications of loans can become increasingly difficult where funding arrangements seek to include a form of return linked to some non-standard measure such as a profit share, rather than ‘standard’ interest. That return may be difficult to analyse as being above or below the market interest rates.

The concept of ‘equity or loan interest’ is a ‘primary interest’ or ‘secondary interest’ – which are, in turn, defined as:

  • ‘primary equity interests’/’secondary equity interests’ – actual shares (not the debt/equity concepts);
  • ’primary loan interests’/’secondary loan interests’ – actual legal loans (not the debt/equity concepts).

Accordingly, where the funding arrangements remove some of the essential characteristics of a loan (primarily, an absolute obligation to be repaid at the end of the loan term), but do not constitute a legal share, the DVS – on issue or later variation – would not apply.

Shares

Of course, the issue, or variation of the rights, of shares with/to ordinary or special rights are a regular area for potential value shifts.

They are a regular way of structuring funding arrangements to provide the funding parties with an unequal but agreed access to future returns.

Per the above analysis for loans and the earlier discussion of the CGT basics, care should be exercised when shares are being issued at a premium when not at arm’s length.  Double taxation can ultimately result.

Otherwise, each share related dealing needs to be assessed on its own facts.

Active Participant issue

Private groups may involve more than just one family. The owners may be a smaller group of ‘closely co-ordinating’ owners/investors, but who still deal at arm’s length with each other.

It is worth stressing that that arm’s length dealing may not be enough to prevent application of the DVS rules, given the wide meaning of ‘active participant’.

Practical planning

Because of the potential application of the DVS rules when changes are made to pre-existing lending terms or shareholdings, after value has already accrued in a company, there is an obvious preference to get the planning right from the beginning – so that changes that involve value shifts do not occur.

If changes are needed, a strategy is to ensure the changes do not result in both the down interest and up interest, as needed to trigger the DVS rules.

As noted already, this happens by virtue of the provisions themselves when an interest is issued at a premium (excluded as a down interest), but to the possible later detriment of taxpayers.

But circumstances may arise where taxpayers can ensure that changes only result in all down interests or all up interests.

The ‘all down interests’ scenario is what commonly happens when discretionary entitlement share (‘dividend access shares’) are issued.

If properly structured, such discretionary shares do not have any value themselves, as they do not have any certainty of distributions. As such, they are not an up interest or a down interest. But, note, this will be subject to any related arrangements (e.g. profit share agreements – per the company constitution or contractually) that may govern how the discretionary distributions on the shares will be made.

The issue of such discretionary shares will usually have the effect of reducing the value of pre-existing ordinary shares, so those shares will be a down interest.

As there are only down interests, the DVS rules would not apply.

Conversely, if a private group was wishing to eliminate pre-existing discretionary shares – e.g. so as to revert to fixed entitlements when new shareholders are providing new funding for a fixed ownership interest – there may only be all up interests. All shares may move to a position of certainty of a fixed share of distributions, from a previously uncertain position.

Debt/equity rules 

Overview and why debt/equity rules are important

The debt/equity rules in Division 974 apply to ‘schemes’ (arrangements) to determine what is equity in a company and what is debt in an entity for taxation purposes.

From the company’s tax (as well as other) perspective(s), whether the character of the return to those parties providing funding is deductible interest (a debt deduction) or a dividend (non-deductible distribution – potentially franked) will be of critical importance.

From the point of view of the provider of the funding (investor) the character of the return is important – but so too is whether repayment of the ‘principal’ funds provided to the company will be treated as a (mere) loan repayment or as some form of distribution that could be partly assessable.

These are questions (among other tax treatments not immediately relevant here) the debt/equity rules will determine.

Broadly, in determining what is a debt interest, the test is whether this is an effective obligation of an issuer (borrower) to return to the holder (lender) an amount at least equal to the amount invested. The rules look to the substance of the arrangement. The classification is not necessarily determined by the legal form of the arrangement.

As for equity interests in a company, the rules contain a table (discussed below) that lists four categories of arrangements which give rise to equity interests.

There is a tiebreaker test that applies to interests that pass both the debt and equity tests. Where both the debt and equity tests are satisfied, the tiebreaker test provides that the interest is a debt interest.

The debt and equity tests usually only need to be applied to classify the relevant scheme when ‘it comes into existence’ but, where there are material changes, a new scheme may be taken to arise and the test will need to be re-applied (section 974-100 and, for example, ATO ID 2004/611).

Determining whether an interest is a debt interest

The following summarises the basic test for working out if an interest is treated as debt at the time it is issued.

Five elements are required to satisfy the debt test:

•        there must be a scheme;

•        the scheme must be a financing arrangement;

•        there must be a financial benefit received by the issuing entity;

•        the issuing entity must have an effectively non-contingent obligation to provide a future financial benefit; and

•        there must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received.

First Element – there must be a scheme

The first element of the debt test is the existence of a scheme (section 974-15).

Scheme means any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

Second element – the scheme must be a financing arrangement

The second element is the existence of a financing arrangement (section 974-20(1)(a)).

A financing arrangement is an arrangement entered into by the issuer to raise finance – or to fund another scheme that is a financing arrangement, or to fund the return on another scheme that is a financing arrangement.

A financing arrangement generally involves the contribution to an entity of capital in some form – for example, the provision of loan capital to an entity in return for the issue of a debt interest.

Certain arrangements, such as ordinary employment contracts, are generally not undertaken to raise finance. Such arrangements are not debt (nor equity) interests. Some things are specifically excluded from being financing arrangements, for example, life insurance and general insurance contracts undertaken as part of the issuer’s ordinary course of business.

Third element – there must be a financial benefit received

The third element is the receipt of a financial benefit by the issuing entity under the financing arrangement (section 974-20(1)(b)).

A financial benefit anything of economic value. It includes property and services.

Generally, the financial benefit received will be the issue price specified in the terms of the financing arrangement. It is the amount paid to acquire the financial interest and amounts to be receivable in the future.

Fourth element – the issuing entity must have an effectively non-contingent obligation to provide a future financial benefit

For an interest to be regarded as a debt interest, there must also exist an effectively non-contingent obligation for the issuer to provide a financial benefit to the holder of the interest (section 974-20(1)(c)). The financial benefit to be provided could be a single amount or a number of instalments over time.

To determine whether an effectively non-contingent obligation exists, regard is to be had to the terms, conditions and pricing of the financing arrangement.

The concept is of an obligation that is non-contingent in substance – as opposed to an obligation that is non-contingent only in form.

Where a creditor has a right that becomes due and payable, the debtor’s inability or unwillingness to meet the obligation does not make the obligation contingent.

In some cases involving obligations owed by a number of entities under a scheme, the Commissioner of Taxation has the power to determine who issued the debt interest.

In considering whether there is an effectively non-contingent obligation, artificial and immaterially remote contingencies are to be ignored.

Subordination clauses that preserve the obligation but operate to (merely) postpone enforcement of that obligation to a time that other creditors are paid, do not prevent there being a non-contingent obligation.

When meeting the obligation is dependent only on the debtor’s ability to pay, this is not enough to make the obligation contingent.

But where the creditor’s right to repayment is subordinated to the level of ordinary equity interests, such that the obligation, in a winding up, to repay the creditor is contingent on paying the ordinary equity interest holders, the obligation will be contingent.

In a limited recourse loan arrangement, if the borrower does not repay the amount due at maturity, the lender’s only recourse is to a specified security or asset. This limitation of recourse will also, not of itself, prevent the debtor having an effectively non-contingent obligation to provide a financial benefit.

Where there is an effectively non-contingent obligation, whether the interest passes the debt test will fall to be determined by whether it is substantially more likely than not that the value of the security or asset to be provided will be at least equal to, or exceed, the amount borrowed (i.e. satisfaction of the fifth element discussed below).

Fifth element – it must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received

The fifth element of the debt test is that it be substantially more likely than not that the financial benefit to be provided by the issuer will be at least equal to the value of the financial benefit received (section 974-20(1)(d) and (e)).

The financial benefit to be provided is what the issuer has an effectively non-contingent obligation to provide to the investor and this can include the return of the initial investment amount.

The method of calculating the value of the financial benefit depends on the performance period of the arrangement. If the term is 10 years or less, the value will be calculated in nominal terms. If the term is more or may be more than 10 years, the value of the benefit will be calculated in present value terms (sections 974-35 and 974-50).

The performance period is the period within which, under the terms on which the interest is issued, the issuer has to meet its effectively non-contingent obligations in relation to the interest.

The present value of a benefit is the nominal value of the benefit, discounted using an ‘adjusted benchmark rate of return’.

The adjusted benchmark rate of return is defined as 75% of the ‘benchmark rate of return’ on the test interest.

The benchmark rate of return is defined as the internal rate of return on an investment if the investment were ‘ordinary debt’ of the issuer or an equivalent entity, compounded annually and otherwise comparable with the interest under consideration.

Determining whether an interest is an equity interest

The equity test identifies schemes that will be classified as equity.

As equity, returns under the scheme may have frankable distributions (like dividends) rather than having returns that may be deductible (like interest).

There is a table in section 974-75(1) that lists schemes that are equity interests. A scheme satisfies the equity test if it gives rise to an interest listed at items 1 to 4 of this table. In relation to items 2 to 4 of the table (other than legal membership/share interests), the interest must also be a financing arrangement.

A scheme gives rise to an equity interest if the scheme satisfies the equity test when it comes into existence, subject to it also satisfying the debt test. Under a tiebreaker rule, if a scheme satisfies both the debt test and the equity test, it will be a debt interest (section 974-5(4), also per section 974-70(1)(b)).

Unless an interest satisfies the debt test at the time of issue, entities will issue an equity interest when they issue:

  • a membership interest (such as a share) – item 1;
  • an interest providing returns that depend on the issuer’s economic performance – item 2;
  • an interest providing returns at the discretion of the issuer – item 3; or
  • an interest that may or will convert into such an interest or share – item 4.

In this context ‘returns’ include the return of an amount invested in the interest (i.e. return of capital). An equity interest that is not an actual share is a ‘non-share equity interest’.

Item 1 – an interest as member or stockholder of the company

Unless it satisfies the debt test, any membership interest in a company is an equity interest in that company, whether an ordinary share or a preference share, and whether in a company limited by shares or a company limited by guarantee.

Item 2 – an interest that carries a right to a return that is effectively contingent on economic performance

Item 2 of the table recognises an equity interest where the holder of such an interest has a right to a return that is dependent on the economic performance of the company or certain activities of the company. An example of this would be an interest where the returns are dependent on the company’s profits.

As for the debt test, an equity interest does not generally arise in cases where an employee’s remuneration (e.g. a bonus arrangement) is partly or wholly contingent on the economic performance of a company. This is because a contract for personal services entered into in the ordinary course of the business of an entity is generally not entered into to raise finance.

Item 3 – an interest that carries a right to a return that is at the discretion of the company

Under item 3 of the table, an equity interest exists where the holder of such an interest has a right to a return that is made at the discretion of the company. An investor may, for example, have an interest in an entity that provides a return of a set amount unless the directors determine otherwise. Such an interest is an equity interest.

Item 4 – an interest issued by the company that will or may convert to, or provides a right to be issued with, an equity interest in the company

A holder of an interest issued by the company that carries a right to be issued with an equity interest in the company holds an equity interest in the company under item 4. Similarly, an investor holds an equity interest under item 4, if the interest they hold is issued by the company, and it will or may convert into an equity interest in the company.

Notwithstanding the rights to be issued with, or to convert into, equity interests, there is a general exclusion under section 974-30(1) of the value of that possible (future) equity interest from being counted as a financial benefit to be taken onto account for the debt test. This means that these types of interests may still be equity under the tie breaker rule. Examples are discussed further below in section 4.4.3, including the exception to this general rule in section 974-30(1).

Particular debt/equity interests

Loans with contingent or discretionary returns

Where a loan carries a right to a return that is effectively contingent on aspects of the economic performance of the company or certain activities of the company, it will generally qualify as an equity interest. A right to a return will generally be considered ‘contingent on the economic performance of the company’ where:

  • the payment of returns is dependent on the availability of the company’s profits;
  • the repayment of the original investment amount is dependent on the availability of the company’s profits;
  • the interest gives its holder the right to a percentage of the profits made by the company; or
  • the interest gives its holder a right to set an annual repayment/ return amount if a related company makes a profit.

An example of such an interest could be a loan, where payment of any non-cumulative interest/return is dependent on profits existing each year.

Because, where the loan satisfies both debt and equity interests, the interest will be deemed to be a debt interest as a result of the tie breaker test in section 974-5(4), the way to manage that a loan with such ‘contingent on the economic performance of the company’ terms remains a debt interest could be to:

  • retain the absolute obligation to repay the loan by 10 years – so that the (undiscounted) face value repayment is enough to satisfy the debt test; or
  • (likely more difficult commercially) retain a sufficient base level of return (interest) payable on a loan with a term that exceeds the 10 years, to cause the present value of the loan to satisfy the debt test.

There is also the specific ‘at call’ loan exception discussed below.

‘At call’ loans

Funding may be provided by family or associates by way of ‘at call’ loans.

Such ‘at call’ loans, because they do not have a definite 10 year repayment term and because any interest (return) is at the discretion of the company, may not satisfy the debt test – and so could be treated as equity.

Such an equity treatment would mean that repayments of the loan principal would be treated as an effective return of capital (non-share capital returns) to which the anti-avoidance capital benefit rules in section 45B could apply per section 45B(7) (and see PSLA 2008/10). In summary, the repayment of the ‘at call’ loan principal could be determined to be partly an assessable unfranked dividend – unlikely to be a welcome treatment.

But there is a specific small business turnover carveout for ‘at call’ loans between connected entities, if a company has a turnover of less than $20 million. The carve-out means that a related party ‘at call’ loan will be treated as being a debt interest rather than an equity interest.

A company’s annual turnover (worked out at the end of an income year) is to be determined in accordance with the GST rules.

Private companies with related party ‘at call’ loans that do not qualify for the special carveout would otherwise need to consider whether to change their loan terms, so they are debt interests under the general debt/equity rules.

The company may elect (under section 974-110(1A)) to treat such a change of terms as if it occurred at the beginning of the previous income year. This election must be made before the earlier of the due date for the company’s tax return or the date of actual lodgement for that year. Practically, this timing allows companies to manage (fix) a change of characterisation of an ‘at call’ loan for an earlier income year where that change can only be identified after year end (because of the turnover test), by deeming the changed terms to apply for that earlier year.

Because the turnover test applies on an annual basis, a company may qualify for deemed debt treatment under the debt/equity rules for one year but not the next. This means that related party ‘at call’ loans to the company could change from being debt interests to being equity interests if their turnover exceeds $20 million.

Loans that become equity-convertible notes/interests

Where the providers of funds wish to protect their downside risks by retaining loan characteristics, but also allow for the upside of taking up equity, some form of convertible interest may be proposed.

Such convertible interests, the equity character of which arises from the ability of their holder to possibly become an equity holder in the future, will generally satisfy the equity test – item 4.

Section 974-165 provides an interest is a converting or convertible interest if the interest, or a component part of it, may (or must) be converted into an equity interest in the company or a connected entity. This is equally applicable where the relevant financial arrangement comprises a number of rights or interests, only one of which converts into an equity interest.

But, as noted in the earlier comments on item 4 in the equity test table, the general exclusion under section 974-30(1) of the value of that possible converted equity interest from being counted as a financial benefit for the debt test, means that these types of interests may still be equity under the tie breaker rule.

Section 974-135(4) provides an exemption to this general principle where the holder of a convertible interest has a right to convert the interest into an equity interest in a company. In these circumstances, the issuer’s obligations to repay the issue price will not be considered to be effectively contingent because of the mere existence of the holder’s right to convert. In other words, the convertible interest can still be debt.

Section 974-135 does not contain a similar exception that applies where the issuer (the company) holds the right to convert the note into an equity interest in the issuer. This means the issuer’s right to convert the convertible note would still be considered a relevant contingency for the purposes of the debt test. The discretion that an issuer has about converting the note into an equity interest in the issuer to end any obligations of the issuer, is a contingency that could of itself preclude a finding that there is an effectively non-contingent obligation after the time the conversion choice could be made.

In summary – and depending on the exact wider terms, conditions and pricing of the arrangement – it is likely a convertible interest at the right of the issuer (the company, only) would be considered an equity interest.

Paragraph 25 of TR 2008/3 confirms this:

‘A convertible note that can be converted into an equity interest in the issuer at any time at the issuer’s discretion will satisfy the equity test in subsection 974-75(1). Item 3 in the table in subsection 974-75(1) will be satisfied because the amount of the return on or of the amount invested in the note will be at the discretion of the issuer: the amount of the return will depend on whether and when the issuer exercises its discretion to convert the note. The amount of any interest payable on the note will depend on the issuer’s discretion to convert. Item 4 in the table will also be satisfied because the note is an interest that may convert into an equity interest in the issuing company’.

Accordingly, careful planning, or review, of the terms of any convertible notes/interests is required – to ensure the intended debt/equity treatment will arise.

Equity with preferential returns – redeemable preference shares

Alternatively, providers of funding may be prepared to take up equity with preferential access to profit distributions and later return of capital, including by redemption.

Section 974-135(5) provides that an obligation to redeem a preference share is not contingent merely because there is a legislative requirement, such as section 254K of the Corporations Act 2001, for the redemption amount to be funded out of profits or a fresh issue of equity. Therefore, in applying the debt test to the redeemable preference shares, those company law restrictions can be disregarded.

Where the terms of the redeemable preference shares only specify that they must be redeemed after a specific period of time (subject to the company law requirements), the issuer’s obligation is only to redeem for the redemption price.

In these circumstances, an equity raising by the company to comply with the company law requirements, about funding the redemption, would be a separate arrangement – and not create any convertibility rights in connection with the redeemable preference shares.

The general exclusion under section 974-30(1) of the value of a possible converted equity interest from being counted as a financial benefit for the debt test should therefore have no application to the redemption of the redeemable preference shares in determining the value of the financial benefits to be provided by the issuer under the redeemable preference share arrangement.

In summary, the redemption price (as the ‘simple’ obligation stated for redemption) is not prevented from being included in the value of the financial benefit to be provided by the issuer when applying the debt test. Depending on the exact wider terms, conditions and pricing of the arrangement the redeemable preference shares could be made a debt interest.

Discretionary shares plus agreements

The financial effects of a funding arrangement may be sought to be achieved by a combination of different classes of shares and contractual obligations (in or outside the company constitution, including by shareholder agreements) around how distributions will be made on those different classes of shares.

For example, a group of professionals may see this as a way to calibrate returns to the contributions of the different owners of the business/company.

The overall arrangement is unlikely to give rise to debt interests. It is really a type of structure being used to provide variable profit shares – here by way of a governance structure imposed over the operation of the discretionary share rights.

lssues are more likely to arise under the value shifting rules, if the structure has not been put in place from commencement – or when interests are varied without market value consideration being paid. Otherwise, when owners exit or enter, it would be expected the usual CGT and other tax consequences would be dealt with – even if the structure involves more than a ‘simple’ share.

Employee share schemes 

To access funding by way of the ‘human capital’ – the particular personal skills – of key personnel a private group may wish to provide the incentive of equity ownership in the group, in addition to other periodic financial (cash and benefit) remuneration.

This is not usually a major element in a private group’s funding. Ownership of such groups is held by related parties (often family members) or by a small group of ‘closely co-ordinating’ owners/investors. The introduction of owners outside this group may be consciously refused, or be severely limited so as not to introduce additional complexity to how the group is managed and returns shared.

But there will be a place for the provision of equity in order to access key skills and key personnel in some circumstances.

This section is to provide a very broad overview the Employee Share Scheme (ESS) provisions to be found in Division 83A. Generally, the provisions are directed at ensuring that tax applies to benefits provided by way of ESSs, however there are some concessions.

The discussion will mainly focus on particular aspects/concessions of the ESS that may be of benefit or interest to private groups.

Overview

The ESS provisions apply to include in assessable income the discounts provided by employer companies to employees on ESS interests – being shares or the right to acquire a beneficial interest in a share (e.g. options) – because of their employment with the company.

So there is a threshold issue of determining whether the discount is provided in respect of employment versus because of family or pre-existing shareholder status. (The GVS rules may of course apply even if the ESS rules do not.)

To determine if a discount exists obviously involves comparison to a market value.  Where rights exist to acquire shares in a company (e.g. an option), its market value is to be calculated in accordance with relevant Regulations. Those Regulations broadly require companies to calculate the value of an unlisted right based on its terms (exercise period, price, etc) in comparison to the existing market value of an ordinary share in the company.

The value and timing of tax under the ESS rules of amounts to be included in an employee’s assessable income is dependent on whether the scheme is considered an:

  • deferred scheme – Subdivision 83A-C
  • upfront scheme – Subdivision 83A-B

Deferred schemes

The deferral concessions will apply if the conditions in section 83A-105 are satisfied. It is not a choice made by the company or the employees.

Also note that the deferral mechanism operates in a way that defers the time the taxable discount is calculated – versus deferring when the time when a discount, calculated at the time of grant of the ESS interest, is taxable.

For this reason, deferral may not be seen as a concession and may not be desired – and the company and the employees may prefer to structure for the ESS interests to be taxed up-front.

Whether planning to be in or out of the deferral treatment, for a grant of ESS interests to be eligible for deferred treatment, the following general conditions must be satisfied:

  • the ESS interest is acquired by an employee of the company or a subsidiary of the company;
  • all of the ESS interest acquired under the scheme relate to ordinary shares;
  • the company for which the ESS interest is acquired must not be predominantly in the business of acquiring, selling or holding shares, securities or other investments; and
  • the ESS interest must not result in the employee holding more than 10% of the shares in the ESS company or controlling more than 10% of the votes at a general meeting.

Additional conditions in section 83A-105 will also apply depending on whether the relevant ESS interests are either shares or rights.

If the ESS interest is a share:

  • under the scheme, shares must be available for at least 75% of the permanent employees with at least three years of service; and
  • either:
    • there must be a real risk that under the conditions of the scheme, you will forfeit or lose the share (other than by disposing it); or
    • the share must have been acquired under a salary sacrifice arrangement and the total discount received on the interests acquired during the year (including any other schemes) does not exceed $5,000.

If the ESS interest is a right:

  • there must be a real risk that under the conditions of the scheme, you will forfeit or lose the right (other than by disposing of it, exercising the right or letting the right lapse) or if you exercise the right you will forfeit or lose the share (other than by disposing of it); or
  • the scheme rules must genuinely restrict immediate disposal of the right and the governing rules expressly state Subdivision 83A-105(6) applies to the scheme.

If the general and additional conditions in section 83A-105 are met, timing of taxation is the earliest of the following.

For shares:

  • when there ceases to be a real risk that the recipient will forfeit or lose the shares (other than by disposal) and there are no genuine restrictions preventing disposal;
  • on cessation of the employment to which the interests relate; or
  • 15 years after the share was acquired.

For rights:

  • if the right has not been exercised – when there is no real risk of forfeiture or loss of the right and any genuine scheme restrictions on disposing of the right imposed at the acquisition time have ceased to apply;
  • when the employee ceases employment;
  • 15 years after the right was acquired; or
  • when the right is exercised, provided there is no real risk under the conditions of the scheme, after the right is exercised, that the beneficial interest in the share will be forfeited or lost (other than by disposing of it) and any genuine scheme restrictions on disposing of the right imposed at the acquisition time have ceased to apply.

Upfront schemes

Broadly, an ESS will be considered an ‘upfront’ scheme where it not considered a deferred scheme.

The relevant taxing point under an upfront scheme is the time at which the employee acquired their beneficial interests in the share or right – typically on acceptance of the offer made by the company.

In some circumstances, the assessable discount for ESS interests granted to employees under an upfront scheme may be reduced by $1,000 per employee.

Concessions for start-up companies

A more favourable tax treatment for employees acquiring ESS interests is available for employees of certain small start-up companies. The concession means that the employees do not need to include certain discounts on ESS interests acquired in their assessable income. As such, access to this concession can make the use of an ESS as part of a private group’s funding much more attractive.

In relation to shares, the discount is not subject to income tax and the share, once acquired, is then subject to the capital gains tax system with a cost base reset at market value.

In relation to rights, the discount is not subject to upfront taxation and the right is then subject to capital gains tax with a cost base equal to the employee’s cost of acquiring the right. This may seem less of a benefit than the deemed market value for shares under the concession – but the capital gains tax discount rules (in Subdivision 115-A of the ITAA97) have been modified in relation to ESS interests that are rights to acquire shares and that benefited from the small start-up concession. When determining the acquisition time for a share that has been acquired by way of exercising a right that was an ESS interest subject to the small start-up concession, the time of acquisition for capital gains tax discount purposes is the time at which the right was acquired, and not the time at which the share was acquired. This allows the capital gains tax discount to be available so long as the right and underlying share are sequentially held for 12 months or more.

The small start-up concession applies to the exclusion of all other ESS taxation rules – so that, where eligible for the small start-up concession, the $1,000 up-front concession or the deferred taxation concession cannot apply.

General conditions

The general conditions that apply to all ESS concessions – as noted above – must still be met, namely that:

  • the ESS interest is acquired by an employee of the company or a subsidiary of the company;
  • all of the ESS interest acquired under the scheme relate to ordinary shares;
  • the company for which the ESS interest is acquired must not be predominantly in the business of acquiring, selling or holding shares, securities or other investments; and
  • the ESS interest must not result in the employee holding more than 10% of the shares in the ESS company or controlling more than 10% of the votes at a general meeting.

Extra scheme conditions

The following extra conditions apply to the scheme:

  • the scheme must meet the existing minimum holding period condition (operation of the ESS so that employee hold for three years or until employment ceases); and
  • if the scheme relates to shares, the scheme must meet the existing broad availability condition (entitlement to acquire under the ESS of 75% of Australian-resident permanent employees with at least three years’ service).

Extra employer conditions

To access the concession:

  • no equity interests in the company in which the ESS interest is in, can be listed on an approved stock or securities exchange;
  • the ESS interests need to be in a company that was (and all companies in the corporate group were) incorporated less than 10 years at the end of the most recent income year before the ESS interest was acquired. (It is the company’s income year that is the relevant income year);
  • the ESS interests need to be in a company that has an aggregated turnover (per the concept within the ITAA 1997, section 328-115) not exceeding $50 million for the income year prior to the income year in which the ESS was acquired;
  • the employing company (which may or may not be the company issuing the ESS interest) must be an Australian resident taxpayer. If the ESS interests are not in the employing company, only the employing company needs be an Australia resident taxpayer.

ESS interest conditions

To access the concession, the ESS interest must:

  • in the case of a share – be acquired with a discount of not more than 15 per cent of the market value of the share when acquired; and
  • in the case of a right – have an exercise price (or strike price) that is greater than or equal to the market value of an ordinary share in the issuing company at the time the right is acquired.

The Explanatory Memorandum introducing the concession for small start-up companies (Tax and Superannuation Laws Amendment (Employee Share Schemes) Act 2015) states that this condition ensures the concession only applies in situations in which the ESS interest is issued at a small discount to the employee – and mentions possible abuse through salary packaging arrangements.

The following examples are extracted extracted from the Explanatory Memorandum (paragraph 1.92):

Example 1.1: Shares

Tracy is issued with 10,000 shares in a small Australian start-up entity under an ESS. The shares at issue have a market value of $1 per share. Tracy contributes 85¢ per share under the scheme.

Tracy and the ESS meet all the rules for her 10,000 shares to be covered by the small start-up ESS tax concession.

After 5 years, the Australian start-up entity is sold under a trade sale where Tracy receives $1.50 per share for each of shares.

On acquisition, Tracy receives a discount of $1,500 which is not included in her assessable income (i.e., not subject to income tax). Her shares will then have a cost base for capital gains tax purposes of $10,000.

When Tracy sells her shares she has a discount capital gain of $2,500 this is included in her net capital gain or loss for the income year. If she has no other capital gains or losses for that year, and no capital losses carried forward from a previous year, the $2,500 is then included in her assessable income.

Example 1.2: Rights

Tim is issued with 10,000 ‘out of the money’ options under an ESS operated by his small Australian start-up employer for no consideration. The options allow Tim to acquire 10,000 ordinary shares in his employer after paying an exercise price of $1.50 per right (which is more than the current market value of each share – $1 per share).

Tim and the ESS meet all the rules for his 10,000 rights to be covered by the small start-up ESS tax concession.

After 5 years, Tim exercises each right by paying $15,000. Tim then immediately sells each share for $2.00 with his total proceeds being $20,000.

On acquisition, Tim does not include any amount in his assessable income in relation to the discount received on his options. His options will have a nil cost base for capital gains tax purposes.

There will be no capital gains tax on exercise of his rights and receipt of his shares (due to the availability of a capital gains tax rollover). However, on exercise, the cost base of his shares will be $1.50 per share.

On sale of his shares Tim will have a discount capital gain of $2,500 that is included in his net capital gain or loss for the income year. If he has no other capital gains or losses for that year, and no capital losses carried forward from a previous year, the $2,500 is then included in his assessable income.

Appropriate pricing – plus funding by company

To trigger up-front taxation of a known and acceptable (potentially nil) amount while still structuring ESS arrangements to provide incentive to key employees to commit their special skills (their form of funding), options may be issued (for no consideration) at an exercise price greater than the market value of the company’s shares (i.e. ‘out of the money’).

This can be effective because the taxable discount in respect of unlisted rights is required to be determined in accordance with the valuation tables detailed in the Regulations.

Under these tables, a value is still being attributed to the ‘upside’ represented by the option, even if ‘out of the money’ at grant – but depending on the extent to which the option exercise price exceeds the current share market value, the incentive effect for the employee may still be effective, while providing taxation certainty.

At the extreme, where the exercise price is more than double the market value of the shares at the date of grant and the exercise period does not exceed 15 years, the market value of the option for the purposes of Division 83A will always be nil.

The management of the up-front taxation for the employee may be assisted by the company providing loan funds to pay that tax. This can also apply when/if the options are exercised. Such loan arrangements are common and necessary as any incentive arising for employees from ESS arrangements can be sharply curtailed if the employees find themselves with cash outflow demands from the taxation of their ESS interests, while not being able to realise the ESS interests to pay that tax. Further, even if employees could sell their ESS interests to fund the up-front tax, it acts against the whole intended incentive effect of the ESS arrangements if employees cannot hold onto those ESS interests.

An alternative is to structure the grant of options or shares to the key employees for a price that will reduce or fully eliminate any discount subject to up-front tax. In these situations, the company may still provide loan funds to pay that price, when due on grant and when/if any options are exercised. This approach may be more useful in a more mature business – where there is not expected to be a significant increase in the value of the company’s shares as the company moves from a ‘start-up’ with unproven but potentially valuable IP and other assets to a more established and profitable business.

Points to consider in respect of company loans to support ESS (funding) arrangements:

  • dividends paid on purchased shares can be used to reduce the outstanding loan balance;
  • typically such loans are provided on the basis that any security provided to the company is  on a limited recourse basis – limited to the underlying options/shares – so that the incentive effect for employees is not diluted by the borrowing risk;
  • Division 7A (shareholder loan) issues arise where the loan is made to an employee (or their associate) who is already a shareholder of the company – so that loan arrangements are most simple when supporting the initial recruitment of key personnel;
  • fringe benefits tax issues can be managed via the ‘otherwise deductible’ rule where the employee is the holder of the options/shares and the borrower – but not where an associate is the holder/borrower;
  • Corporations Act issues need to be considered around companies lending to fund an acquisition of its own shares; and
  • it will be necessary to consider how an outstanding loan balance will be dealt with if an employee leaves employment – immediate recovery may be required, as the incentive effect will no longer be relevant.

Shadow plans

A shadow equity plan is essentially a bonus scheme, albeit one under which the amounts payable to a key employee are linked to the value of notional ‘shares’ in the company under a contractual arrangement versus the employee acquiring ‘real’ options/shares.

The tax effects are not as potentially favourable as a ESS arrangement – the bonus amounts will be ordinary assessable income and not capital gains, as no actual options/shares are acquired.

But use of shadow equity plans may be preferred to prevent minority interest holders appearing on the share registry of private groups, while still providing a mechanism to reward key employees in a way aligned to how the contribution of their skills improves the value of the group.

Franking credit issues that can affect equity raisings 

The Tax Laws Amendment (2023 Measures No. 1) Act 2023 enacted integrity provisions in sections 202-45(e) and 207-159 of the ITAA97 which broadly make certain company distributions funded by capital raisings unfrankable.

These integrity provisions apply from 28 November 2023 and address concerns that companies with excess franking credits were using capital raisings to fund fully franked distributions1– where there was no substantive change to a company’s economic circumstances but the distribution had the result of releasing franking credits from the company (see Taxpayer Alert 2015/2).

Section 177EA of the ITAA36 could potentially apply to such a situation but relies on the Commissioner making a determination, whilst these integrity provisions operate automatically.

As with much recent tax legislation, the drafting of these integrity provisions goes much wider than the problem they seek to cure and, as such, the provisions will need to be considered each time a company carries out an equity raising, where franked distributions are paid either before or after the raise.

To understand the potential impact of these integrity provisions it is relevant to review their terms.  Section 202-45(e) deems a distribution to be unfrankable where all of the following conditions of section 207-159(1) of the ITAA97 apply to the distribution: 

  • either:
    • the entity has a practice of making distributions of that kind on a regular basis and the relevant distribution is not made in accordance with that practice; or
    • the entity does not have practice of making distributions of that kind on a regular basis;
  • there is an issue of equity interests in the entity or any other entity (whether before, at or after the time at which the relevant distribution was made);
  • it is reasonable to conclude, having regard to all relevant circumstances, that:
    • the principal effect of the issue of any of the equity interest was the direct or indirect funding of a substantial part of the relevant distribution or the relevant part; and
    • any entity that issued, or facilitated the issue of, any of the equity interests did so for a purpose (other than an incidental purpose) of funding a substantial part of the relevant distribution or the relevant part; and
  • the issue of equity interests was not a direct response in order to meet a requirement, direction or recommendation from APRA or ASIC.

Section 207-159(2) outlines relevant matters which should be taken into account in considering whether a company has a distribution practice including the nature of previous distributions before the relevant distribution, the timing and amount of the distribution, extent of franking and any explanation provided by the company for the distribution.

Section 207-159(4) outlines matters which should be taken into account in determining whether the issue of equity interests was for the purpose of funding the subject distribution.  This includes the timing of the equity issue/s and the subject distribution, the amount of the equity issue versus the amount of the subject distribution, the extent of change of financial position of the entity which made the subject distribution and the entity which issued the equity, the use of the funds from the equity issue, the reasons for the equity issue, and the company’s franking history (i.e. deficit or surplus) as compared to history of profits and share capital.

Where a distribution is made unfrankable under section 202-45(e), there are flow on effects in that the recipient’s assessable income will not include a franking credit gross up and such a distribution will not be exempt from dividend withholding tax in the case of a non-resident shareholder.

Common transactions in the SME environment which may be potentially affected by these integrity provisions include:

  • the franked pay out of profits to existing shareholders prior to entry of new third party shareholders or an initial public offering;
  • a selective buyback of an exiting shareholders, where it is intended that the buyback dividend be fully franked, and the buyback is funded by an equity raise amongst remaining shareholders; and
  • restructures using capital gains tax rollovers which may involve the issue of shares (such as the transfer to a wholly owned company in Subdivision 122-A of the ITAA97, the scrip for scrip rollover in Subdivision 124-M and the company interposition rollover in Division 615 of the ITAA97) – where, prior to such rollovers, there may be a pay out of retained profits to existing shareholders.

These common transactions are generally not aimed at releasing franking credits inappropriately, but rather their main purpose is to either pay out retained profits to existing shareholders who were shareholders during the time when the profits were made, or to facilitate the exit of a shareholder. 

Due to concerns raised about the broadness of the wording of section 207-159 and their impact on such common SME transactions, the Federal Government included the following further commentary in a Supplementary Explanatory Memorandum to the Tax Laws Amendment (2023 Measures No. 1) Act 2023:

5.45B  Also, while it is intended that contrived arrangements undertaken by closely held companies to release franking credits to their shareholders are captured by these amendments, family or commercial dealings of private companies where the capital raising and distribution are initiated to facilitate the departure of one or more shareholders from the company are not intended to be affected by the operation of the measure. This would include, for example, unless the facts and circumstances indicate another (other than incidental) purpose:

•        where, as part of a succession plan, a new generation of family members funds and acquires equity in the company and the funds are applied to pay a franked dividend to the exiting generation of shareholders; or

•        to allow a particular shareholder to exit the company (e.g., due to a falling-out between family members), where the departing shareholder is paid a franked dividend funded by capital raised from those shareholders who remain.

The company directors may need to consider whether, in the particular facts and circumstances, existing anti-avoidance provisions in the tax law that deal with, among other things, the streaming of franking credits, would apply.

No changes were made to the actual terms of section 207-159 and so the potential for the section to apply to these situations still remains, from the words of the statute.

The Supplementary Explanatory Memorandum takes the position that there is a link between the equity raise and the franked distribution, but section 207-159 does not apply because the purpose of the equity raise is to facilitate the exit of a shareholder, as opposed to having a non-incidental purpose of funding the franked distribution.  The weight to which one can rely on the Supplementary Explanatory Memorandum’s comments is unclear.

Section 207-159(1) contains many uncertain terms and concepts including what a ‘substantial part’ of the relevant franked distribution means and the assessment of a non-incidental purpose of funding the relevant franked distribution.

The ATO conducted public consultations on section 207-159 between December 2023 and February 2024 with a view to issuing public guidance on the section.  Without such guidance, it is likely that a private ruling may need to be obtained from the ATO in common SME transactions (as outlined above) to obtain certainty in relation to the section’s non-operation.

Practical steps that a company may undertake to try to navigate through section 207-159 include:

  • documenting the company’s prior distribution practice with the aim of showing that the subject distribution is within the scope of such a practice – this will be no help if the company is a start up and has not previously paid dividends;
  • managing future dividends so that it they do not otherwise upset this distribution practice;
  • documenting contemporaneously the reasons for a franked distribution (being non-related to any equity issue) and why it may be in keeping with the company’s distribution practice;
  • documenting the source of the funding of a franked distribution and how the funds raised by an equity issue are used; and
  • considering whether an equity issue both from the company or an related entity in the group may affect the company’s ability to pay franked dividends.

Thin Capitalisation – SME considerations

$2 million threshold – but be aware

The thin capitalisation rules are generally not an issue for most SMEs because of the $2 million de minimis threshold.  This threshold means that the thin capitalisation rules do not apply to disallow debt deductions if the total debt deductions of the entity and all its ‘associate entities’ for the year are $2 million or less (s 820-35 ITAA97).

Although, care always needs to be taken to ensure that the threshold does apply.

First, the definition of ‘debt deduction’ in s 820-40 ITAA97 needs to be considered.  This definition can extend beyond what is ordinarily understood as debt deductions.  For example, under amendments passed this year (explained at 7.2 below), the definition has been broadened to include amounts ‘economically equivalent to interest’.2  The explanatory memorandum to the introductory bill explains that this is intended to capture interest related costs under swaps, such as interest rate swaps.3

Further, the definition has been broadened to include costs not in relation to debt interests issued by the entity being tested.4   That is, debt deductions could now include costs in relation to debt interests issued by another entity.

Secondly, the required analysis of ‘associated entities’ is not the same as for other parts of the ITAA97 and ITAA36.  Section 820-905 of the ITAA97 provides a special definition of ‘associate entities’ that effectively narrows the definition of associate under s 318 of the ITAA36 for the purposes of the thin capitalisation rules.

Recent changes

On 8 April 2024, substantial amendments to the thin capitalisation rules received assent with effect from 1 July 2023 (except for new debt deduction creation rules (discussed at 7.3 below), which commence from 1 July 2024).

Of assistance to SMEs, the $2 million de minimis threshold (discussed at 7.1 above) applies to the new rules (including the new debt creation rules discussed at 7.3 below).

If the $2 million threshold is exceeded, it is necessary to consider whether the taxpayer falls within the categories of entities to which the thin capitalisation rules apply.

Broadly, the previous rules apply to outward-investing entities (broadly being Australian entities that carry on a business in a foreign country at or through a permanent establishment or through an entity that it controls), inward-investing entities (broadly being Australian entities that are controlled by foreign residents or foreign entities having investments in Australia).  The previous rules then apply differently depending on whether the outward or inward investing entity is categorised as a general or financial entity, whether it is a subsidiary or branch and whether it is an authorised-deposit taking institution (ADI).

The new rules introduce a new concept of a ‘general class investor’, which, broadly, encapsulates outward and inward investing entities (as defined in the previous rules) that are not classified as financial entities or ADIs.

General class investors apply the new thin capitalisation debt tests, whereas financial entities and ADIs continue to use the previous rules.

The following three new debt tests apply to general class investors:

  • Fixed ratio test – 30% tax EBITDA: This is the default test if the other two tests are not chosen by the taxpayer.  Under the fixed ratio test, an entity is denied net debt deductions that exceed 30% of its tax EBITDA (broadly, the entity’s taxable income adding back deductions for interest, decline in value and capital works).  Importantly, denied deductions can be carried forward and claimed in the next 15 income years when the entity’s net debt deductions are under the 30% tax EBITDA threshold.
  • Group ratio test: The group ratio test applies similarly to the fixed ratio test except that the maximum permitted percentage of net debt deductions of tax EBITA is not 30% but rather is the ratio of the group’s net third party interest expense to the group’s EBITDA for an income year.
  • Third party debt test: This test denies debt deductions which are not attributable to third party debt (and that satisfy certain other conditions).

The new fixed and group ratio tests are a radical change to the existing asset-based tests.  Taxpayers that previously relied on the 60% safe harbour debt amount may need to implement substantial changes to their debt structures to ensure compliance with the new tests.

New debt creation rules

In addition to the above tests, new debt creation rules have been enacted with the new thin capitalisation amendments, which can also operate to deny debt deductions.  The debt creation rules will apply from 1 July 2024 and to general class investors (as explained above) and certain outward and inward investing financial entities. Importantly, there is no grandfathering of pre -1 July 2024 arrangements, so that the rules will require the analysis of prior year arrangements.

Again, of assistance to SMEs, the $2 million de minimis threshold also applies to the debt creation rules.

There are two scenarios where the debt creation rules can apply.

First, where an entity acquires an asset or obligation from an associate and the entity (or one of its associates) incurs debt deductions in relation to the acquisition.  Debt deductions are denied to the extent they are incurred in relation to the acquisition or subsequent holding of the asset.

Second, where an entity borrows from its associate to fund a payment or distribution (including dividend, trust distribution, return of capital, etc) to that, or another, associate and incurs debt deductions in relation to the borrowing.  Debt deductions are disallowed to the extent that they are incurred in relation to the borrowing.

Anti-avoidance matters

General Comments

While consideration of the anti-avoidance provisions in any detail is outside the scope of the paper, this section seeks to highlight that, aside from the specific rules already discussed, the potential for complications to arise under anti-avoidance provisions should also be borne in mind.  Ideally, time should be taken for a wide ranging reflection on possible risks, if (unfavourable) surprises are to (hopefully) be avoided.

Possible application of anti-avoidance provisions to funding arrangements is most likely when there are changes to pre-exiting arrangements – versus initial set-up.

When changes are made, there are both:

  • tax costs/benefits to be actively considered; and
  • the tax benefits will typically be more discretely identifiable (in comparison to initial set-up) – because there will be ‘before’ and ‘after’ positions from which the tax benefits may be distilled.

In any case, it is practically more common for issues to arise on restructuring than on set-up. So it is important to take the time to seek to ensure the funding structures (any structures) are as fully considered as possible when initially implemented – with a view to the arrangements being flexible enough to accommodate foreseeable circumstances – so that future changes are minimised. 

In pursuing flexibility, funding arrangements often seek to blend the usual legal characteristics of debt, equity or contractual ‘interests’ and their associated ‘returns’ (for example, implementation/use of special/variable shares or loan rights). Those ‘hybrid’ features may attract special interest when the ATO is considering the various anti-avoidance provisions – e.g. in considering the eight factors listed in section 177D ITAA36 to which regard must be had for Part IVA, or the ‘relevant circumstances’ listed in section 45B(8) ITAA36.

Risks can be enlivened from the very nature of the ‘hybrid’ features, not just when there are changes introduced. Above, in the discussion about ‘at call’ loans at section 4.4.2, it was noted that section 45B can apply to cause the repayments of (what might be thought to otherwise be simply) loan principal to be treated as an effective return of capital (non-share capital returns) – so that application of the testing under section 45B necessarily follows for any repayment.

Accordingly, initial implementation must be alert to any such exposure to anti-avoidance provisions inherent in the arrangements by their very nature.

But the risks generally and mostly increase when changes are made.

It is not possible to exhaustively list possible scenarios but some examples, to encourage awareness, are:

  • implementation of new special/variable shares – carrying risks of application of the dividend strip rules in section 177E where value is redirected between shareholders;
  • buy-back, redemption or cancellation of shares as investors/providers of funding exit/enter – possible section 45B concerns;
  • sale of equity with favourable tax outcomes (e.g. small business CGT concessions) with the new owner being funding by vendor finance – whether such funding may be taken to be indicative of the sale itself being ‘contrived’; and
  • streamed franked dividend distributions being loaned back – whether such funding may be questioned as having facilitated the provision franking credit benefits that may be disallowed under section 177EA.

Family trusts

There may be concerns where funds are sourced from associated trusts.

If the trust has made a family trust election, by use of trust monies (loans) or use of trust assets (leases/licences) by a company outside the family group, on anything other than clear supportable arm’s length terms, the ATO may seek argue there to be a distribution under Division 270 and section 272-60, that is subject to family trust distribution tax. See the ATO views and examples in TD 2017/20 such as Example 3.

Example 3 – interest-free loans by a business

33. The Phantom Family Trust has made an FTE and Kit Walker is the specified individual. The trust carries on a commercial retail business which sells goods to customers at market value. At no extra cost, a customer can request the business’s ‘no repayment for 12 months’ deal. This results in an interest-free loan from the trust to a customer for a year.

34. The benefit of the interest-free loan is a distribution transaction. However, in the circumstances it will be inferred that the amount or value of the interest-free loan does not exceed the amount or value of consideration given in return. The interest-free loan is on arm’s length terms and is an ordinary incident of a retail business carried on by the trust.

The ‘distribution transaction’ in this Example 3 is accepted by the ATO as matched by arm’s length consideration received in return, because it is part of a wider arm’s length dealing with an arm’s length customer.

But where such an interest free (or otherwise non-arm’s length on its own terms) loan is made as part of funding arrangements of an entity, closely held but outside the family group, that wider arm’s length context may not exist. Whether family trust distribution tax can apply will depend on that wider context – and it could be expected that issues will arise around whether the funding supports shares held by the trust itself or held by beneficiaries within the family group.

Example 2 from TD 2017/20, while about circumstances quite separate from questions of funding, gives a sense of the ATO’s thinking – that use of trust monies or assets by persons outside the family group should trigger family trust distribution tax. 

Example 2 – use of holiday home, not an incident of a business

31. The Wonder Family Trust has made an FTE and Diana Prince is the specified individual. The trust owns a holiday home. The holiday home is used by Diana’s friends, for no consideration, for four weeks in the year.

32. This transaction is not on arm’s length terms nor an ordinary incident of a business being carried on by the trust. As no consideration is given in return for the use of the property, the full value of that use is a distribution within the extended meaning of ‘distributes’.
But note the article by John Balazs in the Thompson Reuters Weekly Tax Bulletin for 21 June 2019 paragraph 862, about an unreported Federal Court case Mashed Potato Pty Limited v FCT, NSD1757/2018, with facts similar to this Example 2. In that case, the relevant objection to an ATO assessment imposing family trust distribution tax was allowed in full but – as the ATO reversed its position, at the invitation of the court – there were no reasons for decision published.

The article notes that the taxpayer’s submissions were:

1. First, as a matter of construction, FTDT could only be imposed if the (deemed) distribution was made to a beneficiary. In other words, while s 272-60 extended what was a distribution to include the use of the property by someone outside of the family group, that person still needed to be a beneficiary for the tax to be triggered.

2. Secondly, if the Commissioner’s construction of the section was correct, the distribution was made to Mrs H and not to her friends.

3. Thirdly, as MPPL had passed a resolution resolving to distribute all the income for the income year to Mrs H and there had been no diminution in the capital of the trust, no amount could be taxed.

No change to TD 2017/20 has yet been made to reflect whatever basis the ATO adopted to reverse its position in this unreported case.

Section 100A?

There may be issues where there is a use of trust monies (loans), or use of trust assets (leases/licences), by a company (even one within the family group) on anything other than clear supportable arm’s length terms, when the underlying trust income represented by those loan funds or the value of that asset has previously been distributed to beneficiaries with lower tax rates (but the entitlement is typically left unpaid, with the value to be retained in the trust).

The ATO might seek to argue that, by the use of the trust assets for funding the company in this manner, the elements of section 100A (regarding trust reimbursement agreements) are satisfied, so as to seek to tax the prior income distributions (effectively the funding value) to the trustee.


Footnotes

  1. Such distributions may be via a special dividend or a selective buyback. ↩︎
  2. Treasury Laws Amendment (Making Multinationals Pay Their Fair Share— Integrity and Transparency) Act 2024 (Cth) Sch 2 Pt 1 s 24. ↩︎
  3. Explanatory memorandum to Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity And Transparency) Bill 2023 (Cth) [2.159]. ↩︎
  4. Treasury Laws Amendment (Making Multinationals Pay Their Fair Share— Integrity and Transparency) Act 2024 (Cth) Sch 2 Pt 1 s 23. ↩︎