Example
A company borrows $5,000,000 from a controlling shareholder (a connected entity). The terms and conditions of the loan provide that interest is payable on the principal sum at the rate of 7% per annum. The loan does not have a specified repayment date and the lender may call for the funds to be repaid at its absolute discretion. The company does not meet the small business turnover carve-out test.
Assume the benchmark rate of return for the company is 6% per annum.
The following steps determine if the loan is an equity interest
Equity test step 1: is the interest an equity interest?
The interest is an equity interest because the amount of the overall return in the interest is at the discretion of the connected entity (item 3 of the table in subsection 974–75(1) of the Income Tax Assessment Act 1997 ).
Equity test step 2: is there a scheme?
There is a scheme in the form of an arrangement between the company and the connected entity.
Equity test step 3: is there a financing arrangement?
The agreement is an arrangement entered into to raise finance for the company.
The interest is an equity interest unless it is a debt interest.
The following steps determine if it is a debt interest.
Debt test step 1: is there a scheme?
There is a scheme. See step 2 above.
Debt test step 2: is the scheme a financing arrangement?
The scheme is a financing arrangement. See step 3 above.
Debt test step 3: does the company receive a financial benefit under the arrangement?
The company receives a financial benefit under the arrangement, being the $5,000,000 it borrowed from a connected entity.
Debt test step 4: does the company have an effectively non-contingent obligation to provide a financial benefit?
The company has an effectively non-contingent obligation to pay 7% per annum.
Debt test step 5: is it substantially more likely than not that the financial benefit to be provided will be at least equal to or exceed the financial benefit received?
The performance period is more than 10 years because, although there is a possibility that repayment of the loan may be demanded at any time, there is no effectively non-contingent obligation to repay within 10 years. Therefore, the valuation of the benefits is calculated in present value terms (section 974–50 of the ITAA 1997).
The value of the financial benefits is calculated using the prescribed present value formula:
Amount or value of financial benefit in nominal terms
[1 + Adjusted benchmark rate of return]n
The adjusted benchmark rate of return is 4.5% (that is, 6% x 75%).
The amount of each interest financial benefit to be provided by the company is as follows:
Loan amount ($5,000,000) x interest rate payable (7% per annum) = $350,000
Using the present value calculation method, the value of the interest financial benefits to be provided in perpetuity is approximately $7,777,777.
The value of the financial benefits (approximately $7,777,777) that are to be provided by the company is more than the value of the financial benefit of $5,000,000 that it received, so the interest is a debt interest.
Tiebreaker rule
The interest meets both the equity and the debt tests. Therefore, it is characterised as a debt interest.
End of example