Issue
Whether an interest-free loan from a shareholder to a company, repayable in certain specified circumstances, will be treated as a debt or an equity interest for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997).
Decision
The loan will be treated as an equity interest for the purposes of Division 974 of the ITAA 1997
Facts
A family company, 'Company ABC Ltd', requires capital funds.
A shareholder of 'Company ABC Ltd' agrees to lend the capital funds to 'Company ABC Ltd' on the following terms: • the loan is interest free • repayment of the loan principal is to occur only if: the shareholder decides to sell their shares in 'Company ABC Ltd'; or 'Company ABC Ltd' is sold.
The shareholder owns 90% of the share capital in 'Company ABC Ltd', as well as 90% of the voting rights. The remaining 10% of the shares are held by other family members.
Reasons for Decision
Whether the Loan Meets the Equity Test
Subsection 974-70(1) of the ITAA 1997 provides: A scheme gives rise to an equity interest in a company if, when the scheme comes into existence: (a) the scheme satisfies the equity test in subsection 974-75(1) in relation to the company because of the existence of an interest; and (b) the interest is not characterised as, and does not form part of a larger interest that is characterised as, a debt interest in the company, or in a connected entity of the company, under Subdivision 974-B.
Subsection 974-75(1) of the ITAA 1997 provides that a scheme satisfies the equity test in relation to a company if it gives rise to an item set out in the table contained in that subsection. The table then specifies four qualifying items, for example, Item 1: an interest in the company as a member or stockholder of the company Item 2: an interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is in substance or effect contingent on aspects of the economic performance (whether past, current or future) Item 3: an interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return is at the discretion of the company, or of a connected entity of the company, or Item 4: an interest issued by the company that gives its holder or a connected entity of the holder a right to be issued with an equity interest in the company, or in a connected entity of the company.
The interest in question is considered to satisfy Item 3 of the table in subsection 974-75(1) of the ITAA 1997.
The Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 states that: 'Item 3 in the table in subsection 974-75(1) of the ITAA 1997 covers interests that provide a return (whether on or of the investment) to the holder which is at the discretion of the issuer or a connected entity.'
The term 'connected entity' is defined in subsection 995-1(1) of the ITAA 1997 to mean: (a) an associate of the entity, or (b) another member of the same wholly owned group if the entity is a company and is a member of such a group.
The word 'associate' is then defined in subsection 995-1(1) of the ITAA 1997 to have the same meaning as that term does in section 318 of the Income Tax Assessment Act 1936 (ITAA 1936) Subsection 318(2) of the ITAA 1936 defines associates of a company. Pursuant to that provision, an associate of a company can be any other entity, including a person, where that entity/person has a majority voting interest in the company. In this case, the shareholder who provides the loan to 'Company ABC Ltd' holds a majority voting interest in the company and is thus an associate of that company for the purposes of the definition of 'connected entity'.
As the shareholder is a connected entity of 'Company ABC Ltd', and that shareholder can control whether a return is to be paid on the loan by electing to sell his/her shares, then that return is at the discretion of the shareholder. As a result, item 3 in the table at subsection 974-75(1) of the ITAA 1997, is satisfied.
It is pointed out that this type of loan is not an at-call loan for the purpose of subsection 974-75(4) of the ITAA 1997 as the loan is not repayable on demand by a connected entity. Rather, it is repayable only upon the satisfaction of certain specified circumstances. The loan thus constitutes an equity interest.
The equity test is however, subject to the debt test in that if an interest satisfies both the debt test and the equity test, it is treated as a debt interest and not an equity interest by virtue of the application of subsection 974-5(4) of the ITAA 1997.
Whether the Loan Meets the Debt Test
Subsection 974-20(1) of the ITAA 1997 provides:
A scheme satisfies the debt test in this subsection in relation to an entity if: a. the scheme is a financing arrangement for the entity, and b. the entity receives or will receive a financial benefit or benefits under the scheme, and c. the entity has an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when the financial benefit is received, and d. it is substantially more likely than not that the value of the benefit provided by the entity will be at least equal to the value received by the entity, and e. neither the value provided nor the value received are equal to nil.
It is clear that these tests are not satisfied in this matter as the entity, 'Company ABC Ltd', does not have an effectively non-contingent obligation to provide a financial benefit to the shareholder. 'Company ABC Ltd' is required to repay the principal only if certain prerequisites are met, that is, if the shareholder wishes to sell his/her shares, or if the company is to be sold. This is a contingency in both legal form and economic substance; these contingencies are not artificial, but genuinely make the repayment of the principal a contingent matter.
Furthermore, even if the repayment of principal was non-contingent, the debt test would still not be satisfied as the return paid is of principal only. It is not a benefit that will be substantially more likely than not to exceed the value of the capital received by the entity. As the loan may extend for more than ten years before it is repaid, section 974-35 of the ITAA 1997 requires that the valuation of the financial benefit to be provided by 'Company ABC Ltd' must be in present value terms. As no interest is payable, the present value of the financial benefit to be provided must be less than the value of the financial benefit received, (the latter equalling the nominal value of the loan).
Therefore, the interest-free loan from a shareholder to a company, repayable in these certain specified circumstances, will be treated as an equity interest for the purposes of Subdivision 974-C of the ITAA 1997.
Amendment History
Date of Amendment Part Comment 17 November 2017 Keywords Updated to include relevant keywords Legislative Refs Updated to include omitted legislation Reasons for Decisions Updated to reflect legislative changes and references to legislation
Date of Amendment | Part | Comment
17 November 2017 | Keywords | Updated to include relevant keywords
Legislative Refs | Updated to include omitted legislation
Reasons for Decisions | Updated to reflect legislative changes and references to legislation