The equity test is set out in Subdivision 974-C of the Income Tax Assessment Act 1997. The equity test identifies those financing arrangements issued by a company 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 1 to 4 of this table. In relation to items 2 to 4 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, subject to it also satisfying the debt test. (Under a tiebreaker rule, if a scheme satisfies both the debt test and the equity test, it will be a debt interest.). Unless an interest satisfies the debt test at the time of issue, entities will issue an equity interest when they issue:
- a membership interest (such as a share) [item 1]
- an interest providing returns that depend on the issuer's economic performance [item 2]
- an interest providing returns at the discretion of the issuer [item 3], or
- an interest that may or will convert into such an interest or share [item 4].
In this context returns include a return of an amount invested in the interest.
Unless it satisfies the debt test, any membership interest in a company is an equity interest in that company, whether an ordinary share or a preference share, and whether in a company limited by shares or a company limited by guarantee.
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 an interest where the returns are dependent on the company's profits.
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.
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 issued by the company that will or may convert to, or provides a right to be issued with, an equity interest in the company
A holder of an interest issued by the company that carries a right to be issued with an equity interest in the company holds an equity interest in the company. 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 in the company.
Note that an interest which may convert into an equity interest in a company which is not issued by the company or a connected entity of the company will not be an equity interest in the company. For example, if an entity issues an option which gives the holder a right to acquire a share in a company which is unrelated to the issuing entity, that option is not an equity interest in the company. (Of course, if the option is exercised and the option holder becomes a shareholder of the company, the share will be an equity interest in that company.)