Division 974 - non share equity interests

Is an investment in an unsecured note to be issued by a company to a director a non-share equity interest under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997), if the returns and the repayment of the investment are contingent upon the profitability of the company?

Yes. The unsecured note, to be issued by a company to a director, is a non-share equity interest under Division 974 of the ITAA 1997 as the returns and the repayment of the investment are contingent upon the economic performance of the company.

The taxpayer is a private investment company that is wholly owned by two corporate shareholders. The taxpayer intends to issue a finance raising unsecured note with no fixed maturity date, to its director. The payment of returns on the note, and repayment of the investment amount, will be contingent on the existence of company profits. The returns on the unsecured note are to be calculated as a percentage of the after-tax income of the taxpayer company.

The debt and equity rules apply to: - all schemes (as defined in section 995-1(1) of the ITAA 1997) that come into existence after 1 July 2001 that are a share in legal form; and - all schemes that are financing arrangements (as defined in section 974-130 of the ITAA 1997) that come into existence after 1 July 2001.

The debt test under section 974-20 of the ITAA 1997 and the equity test under section 974-70 of the ITAA 1997 are used to determine whether a scheme or combination of schemes give rise to a debt interest or an equity interest, respectively.

A scheme that gives rise to a legal form share (an interest as a member in the company) will give rise to an equity interest at the time it comes into existence, if it does not satisfy the debt test. Unless a financing arrangement scheme satisfies the debt test at the time it comes into existence, that scheme will give rise to an equity interest other than a legal form share (non-share equity interest as defined in section 995-1(1) of the ITAA 1997) in a company, if the interest satisfies one of the equity tests contained in subsection 974-75(1) of the ITAA 1997. Namely the interest: - gives rise to a return or a right to a return that is contingent on the economic performance of the company or a connected entity or part of the company's or connected entity's activities; or - provides for returns that are at the discretion of the issuer or a connected entity; or - gives the holder or a connected entity of the holder the right to be issued with an equity interest in the company or a connected entity, or - will or may convert into an equity interest of the issuer or a connected entity.

The unsecured note will give rise to a non-share equity interest in the company because: - it is an arrangement or undertaking and thereby satisfies the definition of scheme as contained in section 995-1(1) of the ITAA 1997; - it is entered into to raise finance for the company and accordingly, is a financing arrangement as defined in section 974-130 of the ITAA 1997; - the returns and repayment of the investment amount are contingent on the profitability (economic performance) of the company, and as a result, satisfy one of the equity tests in subsection 974-75(1) of the ITAA 1997; and - it will not satisfy the debt test, as there is no effectively non-contingent obligation to provide a financial benefit as required under paragraph 974-20(1) (c) of the ITAA 1997. That is, the issuer will not have in substance and effect, an obligation to pay returns on the note or repay the investment amount, given that these obligations are contingent upon the profitability of the company.