Mergers and acquisitions

Debt and equity rules

The provision

Division 974 of the ITAA 1997 has rules to help work out what equity in a company is and what debt is.

The debt test takes the substance of the rights and obligations attached to the arrangement into account. The way the arrangement is classified does not necessarily merely reflect its legal form.

Key requirements

Equity

A scheme gives rise to an equity interest if it satisfies the equity test at the time it comes into existence. Unless they satisfy the debt test, the following will be equity:

a share
an interest providing returns that depend on the issuer's economic performance
an interest providing returns at the discretion of the issuer
an interest that may or will convert into another equity interest or share.

Debt

The five essential elements to work out whether an instrument is a debt instrument are shown below.

The diagram shows a flowchart of the steps involved in determining if an interest is debt.

Expected tax outcome

The debt or equity classification can be important for a number of tax outcomes, including:

to identify membership interests for consolidation
to work out whether the thin capitalisation measures apply
to work out whether amounts are subject to interest or dividend withholding tax
to work out whether a return on an interest in an entity may be frankable and not deductible (like a dividend) or whether an amount is deductible and not frankable (like interest).

Key things to consider

Ensure the finance products used by the purchaser have been correctly identified for tax treatment according to the debt/equity provisions - in particular, hybrid products such as convertible notes and redeemable preference shares.

For more information, refer to:

Market valuation for tax purposes

Debt and equity tests: guide to the debt and equity tests.

Sections within 02 Outcomes - key provisions relevant to mergers and acquisitions transactions

Last Modified: Friday, 4 May 2012