Tests for debt and equity
The tests for debt and equity interests are found in Division 974 of the Income Tax Assessment Act 1997External Link (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. For example, debt interest classification is important for the purposes of the consolidation measures (in identifying membership interests), and for the thin capitalisation measures. And whether an interest is a debt or equity interest is particularly relevant in determining whether certain returns may be subject to interest withholding tax or dividend withholding tax.
The debt and equity tests determine whether a return on an interest in an entity may be frankable and nondeductible (like a dividend) or may be deductible to the entity and not frankable (like interest).
In determining what is a debt interest, the rules use a single organising principle – the effective obligation of an issuer to return to the investor an amount at least equal to the amount invested. This test has regard to the substance of the arrangement, and the classification does not necessarily reflect the mere legal form of the arrangement.
In determining what is an equity interest, the rules contain a table that lists schemes that, as a general rule, are equity interests. (The term 'scheme' in the context of this legislation is not, of itself, intended to imply tax avoidance schemes. Rather, scheme picks up the broad meaning of that term in section 995–1 of the ITAA 1997). The equity table is divided into four categories of interests that are equity interests.
There is a tiebreaker test that applies to hybrid interests that are both debt and equity interests. Where both the debt and equity tests are satisfied, the tiebreaker test provides that the interest is a debt interest.