When will an 'at call' loan be a debt interest?
An 'at call' loan will satisfy the debt test in two situations:
If the 'at call' loan has a maximum term of 10 years or less, and there is an effectively non-contingent obligation to repay (at least) the amount that was borrowed, the 'at call' loan will be a debt interest. An 'at call' loan with a term of no more than 10 years may be a debt interest, even if the loan is 'interest free'.
If the loan is repayable 'at call' and has no fixed term, in order for it to be a debt interest there needs to be an effectively non-contingent obligation to pay an interest rate that is high enough to pass the debt test on a present value basis (an arm's length interest rate will achieve this).
Tax consequences of a debt interest
If an 'at call' loan satisfies the debt test and is classified as a debt interest, any payments in the nature of interest made by the company on the 'at call' loan may be deductible but cannot be franked.
Whether or not the interest payments would be deductible is determined by reference to the general deduction provisions of the income tax law (in particular, section 8-1 of the ITAA 1997). This requires an assessment of, among other things, the use to which the borrowed funds are put.
The characterisation of an 'at call' loan as a debt interest or an equity interest will not be significant in all circumstances. However, if the company is to pay interest on the loan and wants to be able to claim deductions for the interest paid (subject to section 8-1 of the ITAA 1997), the entity will need to ensure that the terms of the 'at call' loan are such that it will satisfy the debt test.
Section 45B of the Income Tax Assessment Act 1936 (ITAA 1936) will not apply to an 'at call' loan that is classified as a debt interest.
How to make an 'at call' loan a debt interest
If debt treatment is required, the company should review its 'at call' loan funding arrangements and amend the terms and conditions in such a way that the requirements of the debt test are satisfied. A company may want to ensure its 'at call' loans are debt interests if it is seeking to pay interest and wants to be able to claim deductions for the interest paid (subject to section 8-1 of the ITAA 1997).
To ensure debt treatment, the 'at call' loan should be formalised. The term of the loan should either be fixed at no more than 10 years, or, if the loan is for a term greater than 10 years or has no fixed term, an arm's length rate of interest will need to be paid. It is advisable that the loan be documented so that these terms can be demonstrated to be effectively non-contingent obligations of the company. One possible approach would be for the connected entity and the company to enter into a facility agreement making all money outstanding from time to time fall due and be repayable on a date not more than 10 years from the time the facility agreement is entered into.
Generally, this action should have been undertaken by 1 July 2005, when the transitional rules for 'at call' loans end. However, the review of the 'at call' loan will not be important until a transaction occurs in respect of the loan, for example, when the company makes a payment of principal or interest. Prior to a transaction occurring, there will be no major taxation consequences of the 'at call' loan being classified as an equity interest (other than the requirement to keep a non-share capital account - see below).
Amending 'at call' loans entered into prior to 1 July 2001 so they give rise to a debt interest
After 30 June 2005, an 'at call' loan that is altered to either specify a term of 10 years or less, or requires that an arm's length rate of interest be paid, will be treated as a debt interest from the time that the alteration occurred.
The government recently introduced tax law amendments to ensure the material change provisions operate as intended. The amendments ensure that where, before 30 June 2005, an 'at call ' loan was changed so as to be treated as debt, that loan will continue to receive debt treatment after that date (refer to the link to Tax Laws Amendment (2005 Measures No. 5) Act 2005 under the heading 'More information' at the end of this guide).