Debt and Equity Rules

7

What is debt funding and equity funding?

There are broadly two major categories of funding available to a business: debt funding and equity funding.  

From a basic legal point of view and in the context of capital raising, debt funding refers an arrangement which involves a business borrowing money from a lender and taking on an enforceable obligation to repay that borrowed amount and, generally, interest in addition the principal repayment. The return of the borrowed money generally occurs by instalment payments over a period of time. The interest component is referred to as a return on the lender’s investment.  

Equity funding refers to an arrangement which involves a business receiving funding in exchange for the issuing of equity interests in the business. That involves the issuing of shares in respect of a company or the issuing of units in respect of a unit trust. Generally, there is no equity funding opportunity in relation to a discretionary trust as there is no right have any capital contribution paid back and no right to a return.   

There is generally no obligation on the business to pay back the capital investment to the equity holder, at least until dissolution. Instead, the equity holder will have the value of their capital contribution somewhat preserved in the underlying interest holding. For example, a shareholder could sell their shares in a company to liquidate their capital investment. The value of those shares which are sold may have increased or decreased from the time the shareholder acquired the shares when they made their initial investment.  

There is no obligation on the business to reward the equity investor with a return. In the equity context, a return is referred to as a dividend (in respect of shares) or a distribution (in respect of unit holdings). Instead, any return is contingent on the business making net profits. This is distinct from the situation with debt funding where the right to a return for the lender subsists regardless of whether the business has made net profits.  

The tax law largely adopts these legal principles in classifying certain funding arrangements as either debt or equity in nature. However, as will be explored in this article, that is not always the case. The remainder of this article explores the rules which govern classification of funding arrangements and the tax consequences which can flow depending on the way a particular arrangement is classified under those rules.  

The taxation of debt arrangements versus equity arrangements

Prior to the introduction of the debt and equity rules, the tax law accepted the legal characterisation of instruments as debt or equity. The debt and equity rules were created, at least partly, to address concerns that certain exotic legal form instruments were being designed and utilised to exploit the tax system. For example, instruments were being used that were legally classified as a debt instrument but without possessing many (or any) of the qualities that would typify a debt instrument. The debt and equity rules contained in Division 974 of the ITAA 1997 therefore aim to apply a more substance over form approach to classifying instruments as either debt or equity.  

The debt and equity rules are formulaic which is helpful in the process of classifying certain instruments that have a combination of debt features and equity features, for example, redeemable preference shares.  

A peculiar aspect of the debt and equity rules is the potential for a legal form equity interest which satisfies the debt test to be treated as debt instrument (i.e. a non equity share) and legal form debt instrument that does not satisfy the debt test but satisfies the equity test to be treated as an equity instrument (e.g. non share equity interest).   

The most notable difference between arrangements which are viewed as debt or equity for tax purposes is the way returns on the funding are treated.  

A debt interest for taxation purposes

As mentioned, a return on debt funding is an outgoing to the business borrower and interest income to the lender.  

From the financier perspective  

The interest income is assessable income to the lender on payment under section 6-5 of the ITAA 1997.  

From the borrower perspective 

The interest expense payment is deductible to the borrower under section 8-1 of the ITAA 1997. 

An equity interest for taxation purposes

As mentioned, a return on equity funding is an outgoing to the business equity issuer and dividend income to the equity holder. The dividend is taxed under the imputation system as follows:   

From the shareholder perspective  

  • The sum of dividends paid throughout an income year will be assessable income to the shareholder (to the extent the dividends are paid out of profits).  
  • The franking credits attached to the dividends are also assessable income to the shareholder.  
  • The shareholder is generally entitled to a tax offset (refundable to individual shareholders and non refundable to corporate shareholders) for the total value of franking credits attached to the dividend (with a number of exceptions to entitlement to the tax offset in relation to non residents or where there is a breach of a particular integrity measure).  

From the company perspective 

  • The sum of dividends paid throughout an income year will not be deductible to the company as the outgoing is not related to the derivation of assessable income.  
  • The company may attach franking credits to dividends paid to shareholders.  
  • The value of franking credits so attached will give rise to a debit to the company franking account equal to the value of the franking credits.  

The impacts of the classification of instruments under the debt and equity rules

As will be addressed in further detail below, it is possible for a legal form debt to be classified as an equity interest for taxation purposes under the debt and equity rules. The opposite is also possible, meaning legal form equity is capable of being classified as a debt interest for taxation purposes under the debt and equity rules.  

In this way, the debt and equity rules enable four possible categories of instruments:  

  • A share or equity instrument being classified as an equity interest under the debt and equity rules.   
  • A legal debt instrument being classified as a debt interest under the debt and equity rules.  
  • A non share equity instrument that involves a legal form debt instrument being classified as an equity interest under the debt and equity rules.  
  • A non equity share instrument that involves a legal form share being classified as an equity interest in a company under the debt and equity rules.  

The latter two classifications are particularly consequential.  

Effect of classification on the deductibility of returns

As mentioned earlier, interest payments on a debt instrument are typically deductible under section 8-1 of the ITAA 1997. Returns on shares (dividends) will not be deductible under section 8-1, but may be franked.  

A payment which represents a return to the holder of a non equity share will be deductible to the payer under section 25-85. That is, the dividend payment will be treated like a deductible interest payment.  

Conversely, a payment which represents a return to the holder of a non share equity interest is specifically not deductible under section 26-26. That is, the payment will be treated on par with a dividend outgoing (not deductible to the payer) as would be expected of a return under a standard equity instrument.  

Effect of classification on the assessability of dividends

The basic rule under section 44 of the ITAA 1936 is that a dividend is assessable to the shareholder to the extent that the dividend is paid out of profits.  

However, you will note that section 44 has expanded scope to include (in assessable income of the shareholder) any non share dividends which flow to the interest holder of a non share equity interests. Interestingly, there is nothing to say that the non share dividend is assessable only to the extent it is paid from profits.  

As with dividends which flow from basic shares, non resident shareholders in receipt of non share dividends will only be assessed on those shares to the extent the dividends are sourced in Australia. However, note the potential application of withholding tax (addressed under a separate heading below).   

Effect of classification on the imputation system and franking credits

The basic rule is that a dividend paid by a company to a shareholder may have franking credits attached which represent company level tax paid in generating profits.  

As set out under section 202-45 of the ITAA 1997, the imputation system (and the consequential ability to pass franking credits to shareholders) does not apply to dividend payments which flow from legal form shares which are classified as a debt interest under the debt and equity rules (i.e. a non equity share).  

However, per section 202-30 of the Act, the right to frank dividends does apply to non share dividends which flow from a legal form debt instrument which is classified as an equity instrument under the debt and equity rules (i.e. a non share equity instruments).  

As you can see, the debt and equity rules have the effect of aligning tax outcomes for non share equity instruments and basic equity instruments. Simultaneously, the rules create alignment between non equity shares and basic debt instruments.  

Non share instrument, dividend or return of capital?

If a non share instrument is classified as an equity interest under the debt and equity rules, the question arises whether a payment from the company which flows from that instrument should be classified as a dividend or a return of capital or something else.  

For context, the company must keep a non share capital account. The account must always have a credit or nil balance. The amount received in exchange for the issued interest is credited to the non share capital account (to add recognised value to the account balance).  

The account will be debited (to recognise a decrease in value to the account balance) where there is a payment for the surrender, cancellation or redemption of the interest held, or a payment which reflects a reduction in the market value of the interest held. In essence, these types of payments will represent a return of capital.  

The payment of a non share dividend is be treated similar to a dividend to the extent that the amount distributed is not debited against the non share capital account or the ordinary share capital account, because in that case there would be a return of capital. Remember that a non share dividend involves a distribution of money or property to the non share equity interest holder.   

Effect of classification on the application of the thin capitalisation rules

The thin capitalisation rules contained in Division 820 of the ITAA 1997 apply to limit deductions available to a taxpayer from debt interests where certain debt to equity ratios are exceeded.  

These thin capitalisation rules work in tandem with the classification of arrangements under the debt and equity rules. Therefore, outgoings from legal form equity instruments that are classified as debt instruments under the debt and equity rules will be recognised as debt for thin capitalisation purposes.  

Effect of classification on the application of withholding tax

The withholding tax rules contained in Division 11A of Part III of the ITAA 1936 provide that tax must be withheld from dividend and interest payments to non residents. The rate to be withheld depends on whether the payment is of interest or a dividend.  

For withholding tax purposes, a non share dividend will be treated as a dividend and the withholding rate that applies to dividends will apply. Any dividends paid on non equity shares will not constitute a dividend for withholding purposes.  

Conversely, a return on a non equity share will be a treated as interest. A return on a non share equity interest will not constitute interest for withholding purposes.  

As usual, there are some exceptions to these above rules. 

Effect of classification on the application of the deemed dividend rules

The deemed dividends rules (including division 7A) operate to deem certain payments by a company to a shareholder (not repaid within a certain period of time or on complying loan terms) as non frankable dividends.  

The deemed dividend rules capture payments which represent returns on non share equity interests. 

Effect of classification on the application of the commercial debt forgiveness rules

The commercial debt forgiveness rules contained in Division 245 of the ITAA 1997 operate where a creditor forgives a commercial debt owed by a debtor.  

The rules have extended reach to capture as debt instruments classified as debt under the debt and equity rules.  

Business accountant or banker, businessman calculate and analysis with stock financial.

The rules for classifying arrangements as debt or equity for taxation purposes

The debt classification tests

The requirements for an instrument to be classified as a debt instrument are broadly summarised as follows:  

  • There is a scheme which is a financing arrangement for the entity (the borrower); and  
  • The entity (the borrower), or a connected entity of the entity, receives, or will receive, a financial benefit under the scheme; and  
  • The entity has, or a connected entity has, a non contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time the financial benefit is received, or after the time the first financial benefit is received (if there is more than one financial benefit); and   
  • It is substantially more likely than not that the value provided back will be at least equal to the value received (in essence, this will usually mean that the party receiving the financial benefit has agreed pay at least that amount back to the person who provided them the financial benefit); and  
  • The value of the financial benefits received and provided are calculated and are not both nil.  

The below headings address the meaning of some of these key terms.  

What is a financial benefit?

Section 974-160 of the ITAA 1997 provides that a financial benefit can include:  

  • Property 
  • Services  
  • Things of economic value. 

The issuing of an equity interest to that entity or a connected entity does not constitute the provision of a financial benefit. 

When is a financial benefit provided?

Section 974–30 provides that a financial benefit is provided when it is issued to an entity for its benefit. 

What is value provided or received?

If there is a single financial benefit provided, the value provided is a reference to the value of the financial benefit to be paid / provided under the scheme by the entity (borrower) or a connected entity that received the benefit to the lender. Alternatively, if there are multiple financial benefits provided, the value provided is a reference to the sum of the value of all financial benefits provided under the scheme by the entity (borrower) or a connected entity that received the benefit.  

Conversely, the valued received is a reference to the value of the financial benefit agreed to be received under the scheme by the entity (the borrower) or a connected entity. Again, if there are multiple financial benefits provided, the value provided is a reference to the sum of the value of all financial benefits agreed to be received under the scheme by the entity (the borrower) or a connected entity that receives the benefit.  

How to value financial benefits?

As set out under section 974-35, a financial benefit has its value calculated either on nominal terms or underpresent value terms.   

  • On nominal terms if the performance period ends within 10 years after the interest arising from the scheme is issued; or  
  • On present value terms if the performance period ends more than 10 years after the interest arising from the scheme is issued.  

Essentially what this is saying is that where a scheme (instrument) is designed to run for more than 10 years then whether the financial benefit to be repaid is greater than the financial benefit originally lent should be determined by taking into account the present value of money.  

By way of simple example, assume Person A lends $1,000 to Person B on 30 June 2024. The parties agree to a scheme whereby Person B is required to pay back $1,000 over a period of 50 years. Clearly, because of inflation, the $1,000 will be worth less in 50 years than at the time the financial benefit is received by Person B. Therefore, it is understandably appropriate that financial benefits are calculated on present value terms when dealing with long term schemes.  

This time value of money forecasting ensures that the value of financial benefits provided will equal or exceed the amount received (as is required for an instrument to be classified as a debt instrument under the fourth debt test set out above).  

The formula to calculate present value is contained in section 974-50.  

The formula involves an adjusted benchmark rate of return which is 75% of the benchmark rate of return.  

Essentially, the taxpayer must is required to compare the expected rate of return on instruments with the market value of returns over the course of the scheme. That is, the return under the instrument is tested against the benchmark return rate. If minimum required returns (compared with the benchmark market rate) are not obtained, then the present value of the financial benefits provided would tend to be less than the value of the financial benefit provided. Under such circumstances, the fourth debt test criteria would fail and the instrument could not be classified as a debt instrument for taxation purposes.   

Obviously, there can be practical difficulties to determining expected returns under an instrument. For example, returns may be based on various contingencies. As a result, the tax law enables an instrument to be treated as a debt interest where it is substantially more likely than not that financial benefits repaid (provided) will equal or exceed the value of benefits originally granted (received).  

There are a number of further principles to keep in mind when valuing financial benefits and determining the length of a financial arrangement:  

  • If financial benefits depend on variables ordinary used in commercial arrangements, and such variables can be calculated at the commencement of the scheme, the starting value is to be used in calculating the financial benefits.  
  • If an entity to the arrangement has an option or right of early termination of the scheme, the right or obligation to terminate is disregarded in determining the length of the scheme. The exception is where there is an effectively non contingent obligation to exercise that right or option.  
  • If the instrument is a convertible interest, the length of the arrangement ends at the point the interest converts. If is it uncertain whether the interest will convert, the date that conversion is available is not to be used to measure the length of the arrangement.  

What is a financing arrangement?

From the outset, it is important to keep in mind that the financing arrangement requirement does not need to be satisfied if the interest held is a shareholder, as specified in section 974-20. 

A financing arrangement is defined in section 974-130 as a scheme to raise finance or fund another scheme, or part of another scheme, that is a financing arrangement, or to fund a return, or part of a return, payable under another scheme, or part of another scheme that is a financing arrangement.  

Section 974-130 also provides some examples of financial arrangements that are generally entered into or undertake to raise finance:  

  • a bill of exchange,  
  • income securities,  
  • a convertible interest that will convert into an equity interest.  

Section 974-130 then also provides some examples of schemes that are generally not entered into or undertaken to raise finance:   

  • a derivate that is used solely for managing financial risks;  
  • a contract for personal services entered into in the ordinary course of a business 

Thereafter, the section provides a number of schemes that are definitively taken not be entered into or undertaken to raise finance  

  • a lease or bailment that satisfies certain conditions as set out in the section.  
  • a securities lending arrangement under section 26BC of the Income Tax Assessment Act 1936 
  • a life insurance or general insurance contract undertaken as part of the insurer’s ordinary course of business;   
  • a scheme for the payment of royalties (within the meaning of the ITAA 1936), with certain exceptions (as set out in the section).  

What is an effectively non contingent obligation?

A key feature of a debt interest under the debt and equity rules is that the scheme involves an  effectively non contingent obligation to repay to the investor an amount (provided) at least equal to the amount invested (received). Whether an obligation is non contingent rests on a holistic assessment of the instrument.   

The following features do not automatically make an obligation contingent:  

  • That the instrument can be converted to an equity interest.  
  • That the instrument is contingent on any willingness and ability of the borrower to make repayment. Such a risk exists with all debts.  
  • The Corporations Law requirement for preference shares to be redeemed from profits or by a new issue of shares.   

Any conditions of the instrument which are artificial or contrived may be looked at by the ATO in determining whether there was genuinely an effectively non contingent obligation, or whether the effectively non contingent obligation was incorporated primarily to enable the taxpayer to have the instrument defined as a debt interest (and therefore to potentially obtain more favourable tax outcomes e.g. the right to deduct returns).  

Exceptions to the debt tests

As set-out under section 974-25, there is an exception from instruments being classified as a debt instrument in relation to certain short term schemes. The requirements of eligibility include that: 

  • At least a substantial part of a financial benefit does not consist of money or a monetary asset; and 
  • The financial benefit is provided within 100 days of the receipt of the first financial benefit; and 
  • The financial benefit is in fact provided within that period or is not provided within that period because the entity required to provide the benefit neglects to or is unable to provide it within that period (although willing to do so); and 
  • The scheme is not part of a series of related schemes that together are taken to give rise to a debt interest.  

The equity classification requirements  

The equity classification requirements are contained section 974-75. The table in that section sets out different types of arrangements / schemes that will be classified as an equity interest.   

Such interests include:  

  • The interest is in a company as a member of the company (e.g. a share); or 
  • The interest carries a right to a return from the company if the right or the amount of the return is contingent on aspects of the economic performance of the company or another relevant entity, or where the right to a return or the amount of a return is at the discretion of the company or a connected entity of the company.  
  • The interest issued by the company gives the holder (or a connected entity) a right to be issued with an equity interest in the company (or a connected entity).  
  • The interest issued by the company is convertible into an equity interest in the company (or a connected entity).  

When is an interest contingent on economic performance?

Section 974-85 provides that a right or the amount of a return is contingent on aspects of economic performance of an entity if the right or return is contingent on the economic performance of that entity. An interest is not made contingent simply because the receiving entity is not willing or able to pay back the obtained amounts. Similarly, an interest is not automatically contingent where returns are allocated to an interest holder based on receipts or turnover of the business (i.e. gross receipts). However, an interest will generally be contingent where it the interest holders returns are based on net receipts of the business (i.e. gross receipts less expenses).  

What if the debt tests and equity tests are simultaneously satisfied?

Since the requirements for an instrument to be classified as debt or equity are not mutually exclusive, it is possible that certain instruments will satisfy both the debt and equity tests. Such an outcome would be commonly expected in respect of redeemable preference shares (depending on the characteristics of the particular arrangement). Where both sets of tests are satisfied, there is a tie breaker rule in section 974–5. The rule provides that the instrument will be treated as a debt interest.  

What about related schemes, can these be aggregated?

It is possible for related schemes to be aggregated and treated as a single interest under the debt and equity rules.  

Section 975-15 and 975-20 contemplates this and provides that separate related schemes which may not give rise to a debt interest separately (or an equity interest separately) may be aggregated, and at the point may give rise to a debt instrument (as an aggregated instrument). Theoretically, the opposite result could occur where debt interests are aggregated.   

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.