Debt and equity tests: overview
Division 974 of the Income Tax Assessment Act 1997 contains rules to determine what is equity in a company and what is debt in an entity for tax purposes with effect from 1 July 2001.
Transitional rules existed for amounts paid on all interests issued before 1 July 2001. The law as it existed prior to 1 July 2001 continued to operate in relation to those interests until 1 July 2004 unless:
- the terms of the interest were materially altered
- the interest was rolled over
- the original term of the interest was extended, or
- the issuer elected that the new debt and equity rules applied. This transitional election must have been lodged with the Tax Office, generally by 31 December 2001.
The tests for debt and equity interests determine whether a particular interest is a debt interest or an equity interest. The law:
- identifies when a scheme gives rise to a debt interest as distinct from an equity interest
- is used to identify debt for thin capitalisation purposes, and
- is also used to identify debt for the consolidation measure.
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 payments).
If an interest passes one or more items of the equity test table, then, subject to the overriding operation of the debt test, it will be an equity interest. If the equity interest is classified as a non-share equity interest, a non-share capital account is maintained. For more details about the non-share capital account, refer to the guide to the debt and equity tests.
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 is not based purely on legal form.
If an interest can meet both the debt and equity tests, a tiebreaker test applies so that the interest will be a debt interest.
Where the debt and equity rules apply to an interest, a transitional exception from the equity test contained within those rules applied until 30 June 2005 to 'connected entity at call loans' (certain loans between connected entities that are repayable on demand by the lender).
The debt and equity rules were amended by the Tax Laws Amendment (2005 Measures No. 5) Act 2005 to ensure that certain connected entity at call loans to smaller entities would continue to receive exceptional debt treatment after 1 July 2005. For a more detailed explanation of connected entity at call loans (also referred to as 'credit shareholder loans' or 'related party loans'), refer to the guide to at call loans between connected entities.
On 4 March 2003 the former Minister for Revenue and Assistant Treasurer, Senator Helen Coonan, announced that a regulation would be developed to ensure that certain Upper Tier 2 capital instruments issued by Authorised Deposit-Taking Institutions (ADIs) that are banks would be treated as debt for taxation purposes (see press release C012/03).
On 5 August 2004, the former Minister for Revenue and Assistant Treasurer, the Hon. Mal Brough, announced an extension until 1 July 2005 of the existing transitional provisions for certain Upper Tier 2 instruments issued by authorised ADIs that are banks or non-mutual building societies (see press release No.002). On 25 October 2005 Mr Brough announced a further extension until 1 July 2007 (see press release No.090).
The existing transitional provisions will apply to instruments which have been issued prior to 1 July 2001, and amended after 4 March 2003, but before the announced Upper Tier 2 regulation is gazetted, provided the instruments maintain their Upper Tier 2 status.
Various technical amendments of the debt/equity provisions of income tax law were enacted by the Tax Laws Amendment (2005 Measures No. 5) Act 2005. One of these amendments ensured that the issue of non-equity shares after 1 July 2001 would not give rise to a capital gains tax (CGT) event by virtue of sections 104-35 or 104-155 of the Income Tax Assessment Act 1997.
The debt and equity rules aim to improve certainty in the tax law by establishing tests that provide a clearer and more coherent distinction between equity and debt interests.
The major impact will be on financial institutions, life insurers, superannuation funds and large corporates. Small business and individuals are affected to a lesser extent.
The debt and equity tests were introduced in the New Business Tax System (Debt and Equity) Act 2001.
The primary legislative reference is Division 974 of the Income Tax Assessment Act 1997.