• How do you determine whether an interest is an equity interest?

    The equity test is set out in Subdivision 974C of the Income Tax Assessment Act 1997External Link (ITAA 1997). The equity test identifies those financing arrangements issued by an entity that may have frankable distributions (like dividends) rather than having returns that may be deductible (like interest). The law contains a table that lists schemes that are equity interests. A scheme satisfies the equity test if it gives rise to an interest listed at items 14 of this table. In relation to items 24 of the table, the interest must also be a financing arrangement.

    A scheme gives rise to an equity interest if the scheme satisfies the equity test when it comes into existence. Unless an interest satisfies the debt test at the time of issue, entities will issue an equity interest when they issue:

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

    In this context returns include a return of an amount invested in the interest.

    Item 1 – an interest as member or stockholder of the company

    A member or stockholder of a company is a person who holds an equity interest in respect of that company. This would include the common situation of a person holding an equity interest in a company because the person holds a share in the company. A shareholder generally holds a number of rights that attach to the share, such as voting rights, the right to receive dividends, and the right to participate in the residual assets of the company when it is wound up. Shares are issued by companies that are limited by shares, which means that the liability of each shareholder is limited to the unpaid amounts on the shares held.

    An equity interest also arises where a person is a guarantor in respect of a company limited by guarantee. In such a company, a member's liability to contribute to the company is limited by the member's guarantee to contribute up to a specified amount.

    Item 2 – an interest that carries a right to a return that is effectively contingent on economic performance

    Item 2 of the table recognises an equity interest where the holder of such an interest has a right to a return that is dependent on the economic performance of the company or certain activities of the company. An example of this would be a hybrid instrument where the returns are dependent on the company's profits.

    Attention

    An equity interest does not generally arise in cases where an employee's remuneration is partly or wholly contingent on the economic performance of a company. This is because a contract for personal services entered into in the ordinary course of the business of an entity is generally not entered into to raise finance.

    End of attention

    Item 3 – an interest that carries a right to a return that is at the discretion of the company

    Item 3 of the table recognises an equity interest where the holder of such an interest has a right to a return that is made at the discretion of the company. An investor may, for example, have an interest in an entity that provides a return of a set amount unless the directors determine otherwise: the interest is an equity interest.

    Item 4 – an interest that converts to, or provides a right to be issued with, an equity interest

    A holder of an interest that carries a right to be issued with an equity interest in the entity holds an equity interest. Similarly, an investor holds an equity interest if the interest they hold is issued by the company, and it will or may convert into an equity interest. However, where a person holds an option to acquire shares in a company that is provided by a third party, such as in the case of exchange traded options, the holder does not hold an equity interest unless the option is exercised and the option is deliverable.

      Last modified: 26 Mar 2015QC 36047