Are certain preference shares which give a right of security of tenure over a unit in a retirement village 'debt interests'?

Do preference shares held by a resident of a unit in a retirement village constitute a 'debt interest' for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The preference shares held by a resident of a unit in a retirement village do not constitute a 'debt interest' for the purposes of Division 974 of the ITAA 1997.

A retirement village is developed and operated by corporate entities.

The retirement village offers a type of occupancy arrangement to its residents on the basis of a lease, combined with the purchase of preference shares in the corporate village owner.

Residents enter into a lease which allows them to occupy a specific residential unit in the village. However, this lease can be terminated by the owner of preference shares. Thus, for security of tenure, a resident may apply to purchase preference shares in the corporate village owner. Residents pay a significant amount of money, roughly equivalent to the market value of the unit, to acquire these preference shares.

Preference shares are originally issued to the parent company in respect of each residential unit in the village. Initial residents then purchase the preference shares attaching to their unit from the parent company. Subsequent residents generally purchase the shares of the outgoing resident and, if necessary, additional shares may be acquired from the parent company.

The preference shares bear no right to dividends, however they do carry a number of other rights mostly relating to residence in the village (for example, the right to use village bus, a right to vote at resident's meetings) and winding-up

The arrangement which is the subject of this ATO Interpretative Decision pertains to one specific resident in a retirement village. That resident is the third and current occupant of a particular unit in a retirement village. They entered into a lease over their specific unit and also acquired the preference shares associated with that unit from the outgoing, previous resident. The term of the lease exceeds 70 years and the new resident paid a nominal amount to acquire the lease.

The new resident entered into a lease over the unit in the village. A month after entering into the lease they acquired the preference shares from the previous resident and some additional preference shares from the holding company.

The resident entered into the lease over the unit in the retirement village and one month later acquired the associated preference shares. At this time the preference shares satisfied the equity test by reason of Item 1 in the table in subsection 974-75(1) of the ITAA 1997. That scheme does not satisfy the debt test.

The issuer does not have any effectively non-contingent obligation to provide a financial benefit under the scheme of sufficient value to exceed the value of the financial benefit received (being the acquisition price of the preference shares). The preference shares bear no right to dividends, although they do carry a number of other rights mostly relating to residence in the village (for example, the right to use village bus) and winding-up and thus, the value of these rights do not exceed the acquisition price of the preference shares.

The separate scheme entered into by the resident comprising the lease and its associated rights and obligations, is 'related' to the scheme comprising the preference shares. These schemes satisfy the requirements of subsection 974-155(2) of the ITAA 1997 in that although they are not stapled instruments, the preference share scheme is unlikely to be entered into unless the lease scheme was entered into (refer to paragraph 974-155(2)(b)). Further one scheme complements or supplements the other (refer to paragraph 974-155(2)(d)).

In summary, although the lease and the preference shares are two separate schemes, the schemes are related for the purposes of section 974-155 of the ITAA 1997. The two related schemes are treated for the purposes of section 974-20 of the ITAA 1997 as being one 'notional' scheme.

It is considered that the related scheme will not meet the requirements of paragraph 974-15(2)(c) of the ITAA 1997 as it is not reasonable to conclude that the combined economic effects of the scheme is intended to be the same as, or similar to, a debt interest.

In Note 1 to subsection 974-10(2) of the object provisions of Division 974 of the ITAA 1997, it is indicated that 'the basic indicator of the economic character of a debt interest is the non-contingent nature of the returns'.

The arrangement entered into by the resident is intended to compete with other non strata-title retirement village arrangements (refer to paragraph 85 of Taxation Ruling TR 2002/14). As such, the intended operation of the arrangement is that the resident pays an 'incoming' amount, resides in the village for a time substantially less than the period of the lease, and departs, being repaid their incoming contribution less deferred management fees. It is significant that the arrangement is not intended to run its full term and that the intention is for the resident to have a contingent entitlement to receive an unknown amount upon termination of the scheme.

The key economic effect in terms of the debt test is that the resident in this arrangement does not have an effectively non-contingent obligation to be repaid their incoming contribution. In the present case, the right of the resident to be repaid an amount is contingent on a new resident being found to enter the village. The arrangement is similar in this respect to that described in paragraphs 140-143 of Taxation Ruling TR 2002/14. The arrangement does not have the basic indicator of the economic character of a debt interest.

The preference shares held by the resident do not constitute a debt interest for the purposes of Division 974 of the ITAA 1997 as they do not satisfy the general test for a debt interest specified in subsection 974-20(1) of the ITAA 1997.

Furthermore, the related scheme composed of the preference share scheme and the lease scheme does not result in a notional scheme that satisfies the tests for a debt interest and in particular, it fails the requirements of paragraph 974-15(2)(c) of the ITAA 1997.

As such, the preference shares do not give rise to a debt interest under Division 974 of the ITAA 1997.