ATO ID 2003/752: Interest free loan to private company repayable if shareholding is sold or the company is sold: application of the debt-equity interest provisions
Date of decision: 4 August 2003
Year of income: Year ending 30 June 2004
Business line: Private Groups and High Wealth Individuals

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 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
Summary: 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, 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: 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: 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.

Legislative references: Income Tax Assessment Act 1997 Subdivision 974-A section 974-5 section 974-10 Subdivision 974-B section 974-15 section 974-20 subsection 974-20(1) section 974-35 subsection 974-35(1) Subdivision 974-C section 974-70 subsection 974-70(1) section 974-75 subsection 974-75(1) subsection 974-75(4) subsection 995-1(1)
Subject references: Debt equity borderline Debt interest Debt test Equity interest Equity test Loans