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  • Tests for debt and equity

    The tests for debt and equity interests are found in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997). Division 974 tells you whether a particular arrangement gives rise to a debt interest or an equity interest. The debt or equity classification of an interest is relevant for certain tax purposes. The debt and equity tests determine whether a return on an interest in an entity may be frankable and non-deductible (like a dividend) or may be deductible to the entity and not frankable (like interest). Also, being classified as a debt interest can affect what is a membership interest for the purposes of the consolidation measures, and is a key element in applying the thin capitalisation measures. And whether an interest is a debt or equity interest is relevant in determining whether certain returns may be subject to interest withholding tax or dividend withholding tax.

    In determining what's a debt interest, the rules use a single organising principle – the effective obligation of an issuer to return to the holder an amount at least equal to the amount invested. (If a debt interest involves money being lent in return for a promise to repay the loan with interest, the ‘issuer’ of the debt interest receives the loan funds and issues the debt interest and the ‘holder’ of the debt interest lends the funds and receives the debt interest.) The rules have regard to the substance of the arrangement, and the classification is not necessarily determined just by the legal form of the arrangement.

    There is a tiebreaker test that applies to interests that pass both the debt and equity tests. Where both the debt and equity tests are satisfied, the tiebreaker test provides that the interest is a debt interest.

    As for equity interests, the rules contain a table that lists four categories of arrangements which give rise to equity interests, subject to them not also passing the debt test, in which case the tiebreaker rule will apply.

      Last modified: 18 Jan 2017QC 36047