The full Federal Court recently considered whether a dividend access share was a debt or equity interest. The majority concluded that the particular share was a debt interest – as a result, there was no entitlement to franking credits.

What happened in the case?

In D Marks Partnership v Commissioner of Taxation [2016] FCAFC86, one of the issues was whether dividends paid to Quintaste Pty Ltd could be franked.

HL Securities Pty Ltd had issued Z class shares to Quintaste. The relevant terms of the Z class shares were that:

Each share shall be redeemable at the direction of the directors, at any time, for the issue price, and, at the end of 47 months following its issue, shall be automatically redeemed at its issue price and cease to exist at the expiration of that time, whether or not its redemption price has been paid.

The full Federal Court considered whether the Z class shares were an equity interest or a debt interest.

There were three separate judgments. Pagone J concluded that the ‘debt test’ was satisfied. His findings included that:

  • the $10 subscription amount paid for the Z class shares was a ‘financial benefit’; and
  • HL Securities had an ‘effectively non-contingent obligation’ to pay back the $10 subscription price when the Z class shares were automatically redeemed.

Griffith J agreed with Pagone J on these issues, and did not provide separate reasons.

By contrast, Logan J concluded that:

  • the $10 subscription price was so inconsequential that it was of no ‘economic value’ and therefore no ‘financial benefit’; and
  • as a result, there was no ‘effectively non-contingent obligation’ to pay a financial benefit at the time of redemption.

On that basis, Logan J concluded that the Z class share was not a debt interest, but an equity interest.

How does this affect me and my clients?

The dispute may not have arisen if the Z class shares were issued on different terms.

There is now a clearly defined risk for dividends paid on dividend access shares, or preference shares, depending on the terms of those shares.

Advisers should check the terms of the share before paying a dividend.

Any shares that provide for an automatic redemption after 47 months (or some other definite time) are obvious targets that should be reviewed in advance. Many advisers appear to think this time limitation is necessary to avoid triggering a share value shift – but this is not correct.

Advisers may need to recommend amendments to constitutions and that clients issue different classes of shares (on different terms) to fix shares that currently have the debt/equity risk.