The debt test is set out in Subdivision 974-B of the Income Tax Assessment Act 1997. The following flowchart shows the basic test for working out if an interest is treated as debt at the time it is issued. (For ease of exposition, the basic test outlined here does not address more complex situations where two or more entities, or ‘connected entities’, or two or more related schemes are involved).
The flowchart shows that five essential elements are required to satisfy the debt test:
1. |
There must be a scheme. |
2. |
The scheme must be a financing arrangement. |
3. |
There must be a financial benefit received. |
4. |
The issuing entity must have an effectively non-contingent obligation to provide a future financial benefit, and |
5. |
It must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received. |
First element – there must be a scheme
The first element of the debt test that must be satisfied for the interest to be classified as debt is the existence of a scheme. A scheme is defined in section 995-1 of the Income Tax Assessment Act 1997.
- Scheme means any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.
Second element – the scheme must be a financing arrangement
The second element of the debt test that must be satisfied for the interest to be classified as a debt interest is the existence of a financing arrangement.
- A financing arrangement an arrangement entered into by the issuer to raise finance or to fund another scheme that is a financing arrangement, or to fund the return on another scheme that is a financing arrangement
A financing arrangement generally involves the contribution to an entity of capital in some form. For example, a basic financing arrangement would involve the provision of loan capital to an entity in return for the issue of a debt interest.
Certain arrangements, such as ordinary employment contracts, are generally not undertaken to raise finance, and so such arrangements will neither be debt nor equity interests. Some things are specifically excluded from being financing arrangements, for example, life insurance and general insurance contracts undertaken as part of the issuer's ordinary course of business.
Third element – there must be a financial benefit received
The third element of the debt test that must be satisfied for the interest to be classified as a debt interest is the receipt of a financial benefit by the issuing entity under the financing arrangement.
- A financial benefit is defined as anything of economic value. It includes property and services.
Generally, the financial benefit received will be the issue price specified in the terms of the financing arrangement. It is the amount paid to acquire the financial interest. Amounts may also be receivable in the future.
Fourth element – the issuing entity must have an effectively non-contingent obligation to provide a future financial benefit
For an interest to be regarded as a debt interest, there must also exist an effectively non-contingent obligation for the issuer to provide a financial benefit to the holder of the interest. The financial benefit to be provided could be a single amount, or involve a number of instalments over time.
To determine whether an effectively non-contingent obligation exists, regard is to be had to the terms, conditions and pricing of the financing arrangement.
This fourth element of the debt test uses the concept of an obligation that is non-contingent in substance – as opposed to an obligation that is non-contingent only in form.
Where a creditor has a right that becomes due and payable, the debtor’s inability or unwillingness to meet the obligation does not make the obligation contingent.
Where more than one entity has an effectively non-contingent obligation to provide a financial benefit in respect of one issue, there are rules for working out which entity is taken to have issued the interest.
In some cases involving obligations owed by a number of entities under a scheme, the Commissioner of Taxation has the power to determine who issued the debt interest.
In considering whether there is an effectively non-contingent obligation, artificial and immaterially remote contingencies are to be ignored.
Subordination
Subordination clauses that preserve the obligation, and operate to merely postpone enforcement of that obligation to a time that other creditors are paid, do not prevent there being a non-contingent obligation. This may result in the performance of the obligation not occurring, because senior creditors may never be paid in full. Nevertheless, if ultimately the subordinated claim may receive less than the full amount owing only because the debtor has insufficient assets to repay both the senior creditor and the subordinated claim in full, then meeting the obligation is dependent only on the debtor’s ability to pay and this is not enough to make the obligation contingent.
However, where the creditor’s right to repayment is subordinated to the level of ordinary equity interests, such that the obligation to, in a winding up, repay the creditor is contingent on paying the ordinary equity interest holders, the obligation will be contingent.
Limited recourse loans
In a limited recourse loan arrangement, if the borrower does not repay the amount due at maturity, the lender’s only recourse is to a specified security or asset. This limitation of recourse will not of itself prevent the debtor having an effectively non-contingent obligation to provide a financial benefit. Where there is an effectively non-contingent obligation, whether the interest passes the debt test will fall to be determined by whether it is substantially more likely than not that the value of the security or asset to be provided will be at least equal to, or exceed, the amount borrowed.
However, limited recourse loan arrangements can be drafted in a number of ways. If the drafting is such that the obligation ceases to exist, or never comes into existence, that would bring the existence of a debt interest into real question. In such a case, it is necessary to look at the limited recourse loan arrangement as a whole, including considering whether any associated security arrangements give rise to an effectively non-contingent obligation.
Where, in a secured loan, in order to prevent potential problems with insolvent trading, the personal obligation of the debtor is made legally contingent on whether there are sufficient assets to meet the obligation, the personal obligation of the debtor will be contingent. If, however, the right of the secured creditor to proceed against the property constituting the security remains unconstrained, the obligation of the debtor to suffer the creditor to proceed in that way against the security will itself be an effectively non-contingent obligation to provide a financial benefit to the creditor in the form of the security. Provided the amount of the secured indebtedness is not itself affected by the contingency to which the personal obligation is subject, the result will ordinarily be that the security agreement has created an effectively non-contingent obligation in respect of the security.
Fifth element – it must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received
If the issuer has an effectively non-contingent obligation, the fifth element of the debt test requires that it be substantially more likely than not that the financial benefit to be provided by the issuer will be at least equal to the value of the financial benefit received.
- The financial benefit to be provided is what the issuer has an effectively non-contingent obligation to provide to the investor in relation to the interest. This can include the return of the initial investment amount.
The method of calculating the value of the financial benefit depends on the performance period of the arrangement. If the term is 10 years or less, the value will be calculated in nominal terms. If the term is more or may be more than 10 years, the value of the benefit will be calculated in present value terms.
- The performance period is the period within which, under the terms on which the interest is issued, the issuer has to meet its effectively non-contingent obligations in relation to the interest.
An obligation is treated as having to be met within 10 years of the interest being issued if the terms formally exceed 10 years but there is an effectively non-contingent obligation to terminate the interest within 10 years.
- The present value of a benefit is the nominal value of the benefit, discounted using the adjusted benchmark rate of return.
- The adjusted benchmark rate of return is defined as 75% of the benchmark rate of return on the test interest.
- The benchmark rate of return is defined as the internal rate of return on an investment if the investment were 'ordinary debt' of the issuer or an equivalent entity, compounded annually and otherwise comparable with the interest under consideration.
Where an instrument is perpetual it is mathematically impossible to apply the present value calculation formula in subsection 974-50(4) literally. Accordingly, where the value or the amount of the financial benefit on the perpetual instrument is the same for each year, the total value of the benefit on a present value basis can be approximated as:
amount or value of financial benefit in nominal terms / adjusted benchmark rate of return.
Because the number of returns on the perpetual instrument is indefinite, this approximation is a reasonable and intended application of the present value formula in subsection 974-50(4). It results in an appropriate reflection of a present value of a financial benefit provided on the perpetual instrument.