What are the debt and equity tests
The tests for debt and equity interests determine whether a particular interest is a debt interest or an equity interest.
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 definitions and rules determining what is equity in a company and what is debt in an entity for tax purposes are contained in Division 974 of the Income Tax Assessment Act 1997.
Classification of debt or equity interests
The debt or equity classification of an interest is relevant for certain tax purposes, including:
- identifying debt for thin capitalisation purposes
- identifying debt for the consolidation measure
- 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 non-deductible (like a dividend)
- deductible to the entity and not frankable (like interest).
In determining what is a debt interest, the rules use a single organising principle, which is the effective obligation of an issuer to return to the holder an amount at least equal to the amount invested. The rules consider the substance of the arrangement, not just it's legal form.
An interest is determined to be an equity interest if it passes one or more of the test items and it is not subject to the overriding operation of the debt test. If the equity interest is classified as a non-share equity interest, a non-share capital account is maintained.
Where an interest passes both the debt and equity tests, the tiebreaker test provides that the interest is a debt interest.
Special applications of the debt and equity measures
At call loans
An 'at call' loan is a loan to a company by a connected entity (including a controlling shareholder or director) that:
- doesn't have a fixed repayment term
- is repayable on demand by the connected entity (lender).
At call' loans can also be referred to as credit shareholder loans or related party loans.
If a company has a GST turnover of less than $20 million, there is a small business carve-out which means related party at call loans will be treated as being debt interests rather than equity interests.
For a more detailed explanation, see:
Non-equity shares don't give rise to a capital gains tax event
The issuing of non-equity shares doesn't 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.