Issue
Does a debt/equity swap involving a debtor and a creditor, constitute an event under paragraph 707-325(4)(a) of the Income Tax Assessment Act 1997 (ITAA 1997) for the purpose of the rule to prevent the inflation of the modified market value ('anti-inflation rule')?
Decision
Yes. A debt/equity swap involving a debtor and a creditor is considered to be an injection of capital as described in paragraph 707-325(4)(a) of the ITAA 1997.
Facts
The head company of a consolidatable group, company D (the debtor), borrowed funds from an unrelated third party, company C (the creditor).
Under a subsequent arrangement, company D issues shares to company C, in exchange for the discharge of the outstanding debt. The arrangement takes place after 8 December 2000 and less than four years prior to company D forming a consolidated group.
Reasons for Decision
The basic rule for working out the modified market value of an entity that becomes a member of a consolidated group is contained in subsection 707-325(1) of the ITAA 1997. It provides that the modified market value of an entity at the joining time is the market value of the entity at that time based on certain assumptions.
Subsection 707-325(2) of the ITAA 1997 provides that if: • there are one or more events described in subsection 707-325(4) of the ITAA 1997; • that occurred in the four years before the time an entity becomes a member of a consolidated group; and • the modified market value of the entity calculated under subsection 707-325(1) of the ITAA 1997 exceeds what it would have been if none of those events occurred,
then the modified market value worked out under subsection 707-325(1) of the ITAA 1997 is reduced by the amount worked out under subsection 707-325(3) of the ITAA 1997.
Subsection 707-325(4) of the ITAA 1997 contains the events that are referred to in subsection 707-325(2) of the ITAA 1997. Paragraph 707-325(4)(a) of the ITAA 1997 identifies one of the events as an injection of capital into the entity or an associate.
An injection of capital that occurred in the four years before the joining time can only be disregarded if it is made: • into a listed public company through a dividend reinvestment scheme (paragraph 707-325(5)(a) of the ITAA 1997); • in association with the acquisition of shares under an employee share scheme meeting certain conditions (paragraph 707-325(5)(b) of the ITAA 1997); or • on or before 8 December 2000 (section 707-329 of the Income Tax (Transitional Provisions) Act 1997 ).
The distinguishing features of a debt/equity swap involving a debtor and a creditor are such that the creditor releases the debtor from the obligation to repay the debt (or part of the debt) in exchange for the debtor issuing equity (usually shares) to the creditor. Under the arrangement, the creditor acquires membership interests in the entity in return for releasing the debtor from a debt of equivalent value.
The wealth of the debtor has increased by virtue of it no longer having an obligation to repay loan funds. As such, the debt/equity swap is considered an injection of capital captured by the anti-inflation rule.
As company D has issued shares to company C, an event of an injection of capital into the company has occurred. As the arrangement took place after 8 December 2000 and in the four years prior to company D forming a consolidated group, this injection constitutes an event for the purposes of the anti-inflation rule and is not disregarded.
A reduction in the modified market value of company D may be required under subsection 707-325(2) of the ITAA 1997.