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ASPECTS OF THE DEBT AND EQUITY TESTS

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ASPECTS OF THE DEBT AND EQUITY TESTS

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									                        ASPECTS OF
                          THE DEBT
                      AND EQUITY TESTS
                               By Paul Abbey*
    This article discusses issues surrounding the operation of the debt and
equity tests. These tests seek to distinguish debt from equity for certain
purposes of the income tax system by reference to the life of the relevant
instrument and whether the instrument provides contingent and non-
contingent returns. In essence a debt interest provides a non-contingent
return of the initial investment while an equity interest provides a
contingent return. These provisions have a number of surprising nuances
surrounding the concepts of scheme, financing arrangement and contingent
obligation. They distinguish between a scheme and related schemes and
impose more stringent tests for related schemes. They fail to clarify clearly
the means to establish a financing arrangement, a crucial requirement in
the provisions. They also require a “substantive” test for contingency but
fail to provide appropriate legislative guidance for that test.

                               1. INTRODUCTION
    The New Business Tax System (Debt and Equity) Act 2001 (Cth)
(“Debt and Equity Act”) introduced Div 974 into the Income Tax
Assessment Act 1997 (Cth) (“ITAA97”), with the primary object
being to establish tests to determine whether a scheme, or
combination of schemes, gives rise to a debt or equity interest.
     In combination with Div 974, provisions enacted by the Debt and
Equity Act apply this statutory test to certain aspects of the income
tax law. The primary emphasis of this application is to distinguish
interests which give rise to non-deductible, frankable returns and
interests which give rise to deductible, non-frankable returns. The
other major role for the test is to determine debt capital for the
application of the thin capitalisation rules of Div 820 of the ITAA97.


*
    Partner, PricewaterhouseCoopers.

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ASPECTS OF THE DEBT AND EQUITY TESTS

In many other areas of the ITAA97 and the Income Tax Assessment
Act 1936 (Cth) (“ITAA36”), including most of the grouping and
membership tests contained in each Act, the classification of shares
as debt interests or the classification of debt as an equity interest is
not relevant.
     The purpose of this article is to discuss a number of issues
surrounding the operation of the provisions contained in the Debt
and Equity Act. It is not intended to provide a survey of the entire
regime. Prior to the discussion of these issues, the requirements to
establish an equity interest and debt interest are explained in
rudimentary terms.
          2. CONTINGENT AND NON-CONTINGENT
                      OBLIGATIONS
     Whereas the distinction between debt and equity for tax purposes
normally depends upon the legal characterisation of the instrument
issued, the Debt and Equity Act seeks to distinguish debt interests
from equity interests by relying on the notion of contingent and non-
contingent obligations. The legislation assigns an equity character to
interests which have returns of a contingent nature and a debt
character to interests which have returns of a non-contingent nature.
     This contingency test combines with a valuation test to arbiter
debt and equity. This valuation test summarily presumes that ten
years is an appropriate distinction between nominal and real values.
As a result, any instrument which provides a non-contingent return
of the initial investment within ten years of issue is deemed to be a
debt interest while a non-contingent return of the initial investment
some time after ten years of issue may not prevent an instrument
from being characterised as an equity interest.
     The basis for the “contingency” distinction is explained in para
1.9 of the Explanatory Memorandum (“EM”) to the Debt and Equity
Act:
    Under the new law, the test for distinguishing debt interests from
    equity interests focuses on a single organising principle – the
    effective obligation of an issuer to return to the investor an amount at




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                                                                         P ABBEY

       least equal to the amount invested. This test seeks to minimise
       uncertainty and provide a more coherent, substance-based test which
       is less reliant on the legal form of a particular arrangement. It
       provides greater certainty, coherence and simplicity than is
       attainable under the current law.
     This “organising principle” is said to be reflective of the risks
adopted by equity and debt holders. The EM states at para 1.6 that
the test:
       ... recognises the fundamental difference between equity holders of
       a company, who take on the risks associated with investing in the
       activities of the entity, and its creditors, who, as far as possible,
       avoid exposure to that risk.
      The EM further states that the test is consistent with accounting
standards and the regulatory regime for Australian deposit-taking
institutions (“ADI”).1
     The adoption of this “organising principle” obviously excludes
all other relevant criteria to the determination of debt and equity
from consideration. The result is that instruments which in many
respects are fundamentally similar will receive a different treatment
under this test, should the returns on one investment bear a
contingency.
     The arbitrary nature of this distinction is demonstrated by the
treatment which will arise for a company that has the option of
issuing one of two instruments: either an unsecured, subordinated,
resettable note; or a “reset preference share”. The note would
normally receive a debt treatment under Div 974 compared to the
equity treatment of the preference share because the return on the
preference share is dependent upon the profits of the relevant
company, which are inherently contingent. Yet, notwithstanding this
characterisation, both instruments may be similar in regard to
conditions such as: the term; the rights to vote and participate in the
decision making of the company; the level of security and ability to


1
    See Explanatory Memorandum to the Debt and Equity Act, para 2.151.

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be repaid on a wind-up of the company; the stipulation of the rate of
return and the ability of the company to reset the rate of return; and
any conversion into ordinary shares of the company (which may be
on the satisfaction of certain conditions including at the election of
the holder).2
                            3. EQUITY INTEREST
      The debt and equity legislation is structured around the existence
of a “scheme”2 or “related schemes”. The determination to be made
by a taxpayer is whether a scheme (or related schemes) gives rise to
a debt interest or equity interest. This will occur if the scheme (or
related schemes) satisfies the debt test or equity test respectively. It is
possible for a scheme (or related schemes) to satisfy both the equity
test and debt test and, in this circumstance, the debt test will prevail
and the scheme will give rise to a debt interest.3
      A scheme gives rise to an equity interest in a company if it
satisfies the equity test in regard to an interest when it comes into
existence. This existing interest will be the equity interest. A scheme
will satisfy the equity test if it gives rise to an interest that satisfies
one of the four following criteria:
     1. it is an interest in a company as a member or stock holder;
     2. it is an interest that carries a right to a variable or fixed
        return from the company where the right or the amount of
        the return is in substance or effect contingent on the
        economic performance of the company, a part of the
        company or a connected entity;
     3. it is an interest that carries a right to a variable or fixed
        return from a company if either the right or the amount of the
        return is at the discretion of the company or a connected
        entity; or

2
  The similarity between such a note and a reset preference share can be identified
by comparing the terms of “Leighton Notes” issued by Leighton Holdings Limited
in “Toll RPS” issued by Toll Holdings Ltd, both of which were issued in 2003.
3
  It would seem equally possible to satisfy neither the debt test nor the equity test.



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     4. it is an interest issued by a company that gives its holder a
        right to be issued with an equity interest in the company or a
        connected entity of the company or is an interest that will or
        may convert into an equity interest in the company, or a
        connected entity of the company.
      In summary, the equity test is satisfied if a company issues an
interest that is either shares or has profit tested returns or
discretionary returns or is convertible into equity. Apart from the
first criterion, the remaining criteria only satisfy the equity test if the
scheme is also a financing arrangement (a concept discussed below).
                          4. DEBT INTEREST
      A scheme will give rise to a debt interest if it satisfies the debt
test. A scheme will satisfy the debt test in relation to an entity if the
following conditions are all satisfied:
     (a)   the scheme is a financing arrangement for the entity; and
     (b)   entity or a connected entity receives or will receive a
           financial benefit or benefits under the scheme; and
     (c)   after (b) has occurred, the entity, alone or together with the
           connected entity, has an effectively non-contingent
           obligation under the scheme to provide a financial benefit
           or benefits to one or more entities; and
     (d)   it is substantially more likely than not that the value of the
           financial benefits provided under the scheme will at least
           equal the value of the financial benefits received (on the
           basis both are not nil).
     If this test is satisfied, the debt interest is deemed to be the
interest that carries the effectively non-contingent obligation to
provide financial benefits. It is deemed to be issued when the first
financial benefit is received.




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ASPECTS OF THE DEBT AND EQUITY TESTS

               5. SCHEME AND RELATED SCHEMES
     As discussed, the debt and equity borderline is founded on the
existence of, at the least, a scheme.4
5.1 Scheme
     For this purpose, “scheme” takes its definition under s 995-1 of
the ITAA97 which provides:
     Scheme means:
           (a)       any arrangement; or
           (b)       any scheme, plan, proposal, action, course of action or
                     course of conduct, whether unilateral or
                     otherwise.5
    Further, in s 995-1 of the ITAA97, “arrangement” is defined to
mean:
    Any arrangement, agreement, understanding, promise or undertaking,
    whether expressed or implied, and whether or not enforceable (or
    intended to be enforceable) by legal proceedings.
     It is undoubtedly helpful that scheme means scheme and
arrangement means arrangement. In the Shorter Oxford English
Dictionary, the definition of scheme includes a plan, design or
program of action. An arrangement includes, in its definition in this
dictionary, a structure or combination of things for a purpose.
      Reference to these definitions would obviously suggest a strong
relationship between the use of the definition of scheme (including
the definition of arrangement) in Div 974 and its use under s 177A
of Pt IVA. Although for the purposes of Pt IVA, a scheme can
comprise a single action or event, it is often understood to comprise a
number of different proposals, actions or events, often undertaken by
different entities at different times. In Taxation Ruling TR 2002/16,


4
  The Explanatory Memorandum at para 2.160 states that the use of “scheme” to
apply the equity test and debt test was adopted to allow the linkage of benefits.
5
  Section 974-155.

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the Commissioner discussed the application of Pt IVA to stapled
securities which involved the issue of a preference share and loan
note. In para 157 of this ruling, the Commissioner stated that
although the scheme would vary from case to case, it would always
include:
     •     the stapling of an interest in the note to a preference share
           and the agreement that the principal on the note is payable
           only to the parent company and not to the investors;
     •     the notes being perpetual;
     •     distributions on the interest in the note being referable to an
           interest rate but having equity characteristics; and
     •     distributions on the notes being contingent upon profits
           which may represent an application income-derived.
     It is clear from this ruling that for the purposes of Pt IVA the
Commissioner would consider the relevant scheme to include the
issue of the note and the issue of the preference shares and all of the
associated agreements, terms and conditions surrounding each issue.
It could be expected the same interpretation would apply under
Div 974, especially given the dictionary definitions of scheme and
arrangement.
     Yet, this view would seem contrary to the drafter’s intent. The
concept of scheme under the Debt and Equity Act is not intended to
embrace the width possible under Pt IVA and, it appears that the
intention of the legislation is that a scheme would comprise no more
than, say, the issue of a preference share or the issue of a debenture.
     An example of the narrow operation of the term “scheme” for the
purpose of this legislation is the following statement from para 2.162
of the EM:
     For example, if a company issues an ordinary share and, under a
     related scheme, guarantees to repay the issue price after five years, the
     ordinary share will not be an equity interest if the related schemes of
     the share and the guarantee together constitute a debt interest.




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     This narrow approach to the interpretation of “scheme” is
explained in para 2.22 of the EM:
   It is a question of fact depending on all the relevant circumstances
   whether a series of transactions are part of a single scheme or
   constitute more than one scheme. Merely because transactions are
   undertaken under one agreement does not necessarily mean that they
   are all part of the one scheme. For example, an employment contract
   that provides for the payment of salary and, in addition, the issue of
   shares in the company to the employee would not ordinarily
   constitute a single scheme for the purposes of the debt/equity tests.
   Rather it would usually be seen as constituting two separate
   schemes: one for the payment of salary and the other for the issue of
   shares. Similarly, without limiting the Commissioners discretion or
   scope of regulations, a financing arrangement and a hedging
   transaction (eg a derivative) would also usually be seen as
   constituting two separate schemes. To enable specific circumstances
   to be taken into account, the Commissioner has a discretion to treat a
   particular scheme as constituting two or more separate schemes.
   Regulations may also be made to provide further guidance on when a
   scheme is treated as two or more separate schemes. [Schedule 1,
   item 34, subsections 974-150(2) and (3)].
      From para 2.162, it appears the issue of the ordinary share is
itself a scheme. This scheme will presumably comprise the actions of
the company in issuing the share and the actions of the shareholder in
subscribing for the share. The terms and conditions of the share,
particularly any concerning its future redemption or cancellation, are
also likely to be part of the scheme. The granting of a guarantee to
repay the issue price of the share after the elapse of five years from
its issue appears to be a separate scheme. Yet, without guidance, a
taxpayer conversant in the jurisprudence surrounding s 177A would
probably have thought that issue of the share and the grant of
associated guarantee could comprise a single scheme for the
purposes of the debt and equity tests.
5.2 Related Schemes
     The narrow interpretation of “scheme” is due to the inclusion of
the concept of “related schemes” in Div 974, as both EM paragraphs


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quoted indicate. This new concept operates when seeking to establish
both a debt interest and an equity interest, ie related schemes can
give rise to a debt interest or equity interest.
     For this purpose, Div 974 proposes that schemes can be related in
any way.6 By way of statutory example, schemes can be related to
one another if they are based on stapled instruments, depend upon
each other for effect or operation, complement or supplement each
other or commercially would be unlikely to be entered into
individually.7 Although a preference share stapled to a note issued by
a financial institution for regulatory capital purposes (ie to qualify as
Tier 1 capital) constituted a single scheme under Pt IVA for the
purposes of TR 2002/16, this would seem a typical combination of
related schemes under Div 974.
     The related scheme is subject to a more demanding test to
constitute a debt interest or equity interest than a simple scheme. For
instance, two or more related schemes will give rise to a debt interest
in an entity if, inter alia;
         •    the entity enters into or participates in both schemes;
         •    a single scheme with the combined effect or operation of
              both schemes would satisfy the debt test; and
         •    it is reasonable to conclude that the entity intended the
              combined economic effects of the schemes to be the same
              as or similar to the economic effects of a debt interest.
     The related scheme test can be satisfied even though the
constituent schemes come into existence at different times and
neither scheme individually gives rise a debt interest. However, the
related scheme test will not apply (nor be required) if each
constituent scheme individually gives rise to a debt interest.
    As can be observed, for a debt interest to arise under related
schemes additional requirements must be satisfied. The first

6
    Section 974-155(1).
7
    Section 974-155(2).

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ASPECTS OF THE DEBT AND EQUITY TESTS

requirement is that the entity has entered into or participated in both
schemes. This requirement would be satisfied in the example
contained in para 2.162 of the EM, but the requirement is harder to
satisfy for certain stapled issues undertaken to satisfy regulatory
capital requirements where a loan note may be issued by one group
company and a stapled preference issued by another. In this situation,
it may be necessary to establish that one entity caused the other to
participate in one or more of the schemes to apply the debt test to the
related schemes.
     The next requirement is that a single scheme with the “combined
effect or operation” of both schemes must satisfy the debt test. Thus,
the requirement of Div 974 is that a hypothetical scheme which has
the effect or operation of the related schemes actually undertaken
must satisfy each of the requirements of the debt test. It would seem
that this hypothetical scheme should probably include all the
transactions, which comprise each related scheme so that it has a
combined operation of those schemes. This may not be appropriate,
however, if the effect of the scheme is not realised by considering all
of the constituent parts.
      Irrespective of these concerns, the hypothetical scheme must then
be subject to each of the requirements of the debt test. This means
that the hypothetical scheme must be a financing arrangement for the
entity; that under the hypothetical scheme the entity will receive
financial benefits and have an effectively non-contingent obligation
to provide financial benefits; and that it is substantially more likely
than not that the value of the financial benefits provided will at least
equal the value of the financial benefits received. There are
obviously some difficulties in the logical application of this
provision. For example, it may be difficult to conclude that a
hypothetical scheme has raised finance for an entity.
      The final requirement is that it must be reasonable to conclude
that the entity, or another participant to the related schemes, intended
that the combined economic effects of the schemes would be the
same or similar as the economic effects of a debt interest. This test
requires determination what the economic effects of a debt interest


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                                                               P ABBEY

are and then a reasonable conclusion that the entity intended the
related schemes to have this combined economic effect. Based on the
words of s 974-15(2), it would appear that this conclusion should be
reached on an objective basis.
     A similar approach applies the equity test to related schemes and
treats two or more schemes as giving rise to an equity interest if each
is not already an equity interest. This test also requires, inter alia, the
relevant company to participate in both schemes and a conclusion to
be drawn about the intended economic effects of the related schemes.
     Given the width of the concept of the scheme arising from the
jurisprudence of Pt IVA, it is unclear why the legislation needed to
establish a related scheme test and why the requirements of that test
are so ambiguous.
5.3 Treatment of Related Schemes
     Once two or more schemes are treated as related schemes, the
legislation seeks to deal with them collectively.
     Under this treatment, any distribution made under one
constituent scheme is deemed to be made in regard to the debt
interest or equity interest which arises from the related schemes. The
legislation itself provides the example of a company that issues a
convertible note with a related company providing a binding
undertaking that the option on the convertible note will be exercised.
The convertible note and the undertaking are each separate schemes
which as related schemes give rise to an equity interest in the
company which issues the convertible note. As a result, any returns
made on the note are taken to be returns in regard to the equity
interest. The taxation treatment of these returns under any provision,
whose operation depends upon Div 974, is determined on this basis.8




8
    Section 974-105.

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6. FINANCING ARRANGEMENT
     Apart from the issue of membership interests in a company (ie
shares), a scheme must be a financing arrangement to give rise to a
debt or equity interest. For this purpose, s 974-130 provides that:
     A scheme is a financing arrangement for an entity if it is entered into
or undertaken:
      (a)      to raise finance for the entity ...; or
      (b)      to fund another scheme or part of another scheme that is
               a financing arrangement under paragraph (a); or
      (c)      to fund a return, or part of a return, payable under or
               provided by or under another scheme or part of another
               scheme, that is a financing arrangement under
               paragraph (a).
     At least two issues arise from this provision.
      First, the expression of the test in this manner makes it unclear
whether it poses a factual test or a purposive test. If it was merely
intended to be a factual test, then the legislation should probably say
that the scheme is a financing arrangement “if it raises finance”. By
raising consideration of what it is “entered into or undertaken” to do,
there is an implication that it requires determination of the purpose of
the participants to the scheme rather than the outcome of their
actions.
    The EM to the Debt and Equity Act does not resolve this
concern. Paragraph 2.7 of the EM states that all of the circumstances
and features of an arrangement should be considered to determine
whether it is a financing arrangement and, in this regard:
   The intentions of the parties to the arrangement may be relevant but
   are not determinative.
     Paragraph 2.8 of the EM discusses a range of transactions and
whether they constitute financing arrangements. This discussion
focuses on events and outcomes, rather than intent and implies that
the test is meant to focus on whether finance is raised rather than
whether there is a purpose to raise finance. This suggests that the

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reference to “entered into or undertaken” is designed to ensure that
financing arrangements can include transactions that are meant to
raise finance but fail to (although this notion is not an entirely
comfortable outcome).
     Secondly, the test of a financial arrangement is determined by
whether the scheme is entered into or undertaken “to raise finance”.
The term “finance” is not defined in the ITAA97. Importantly, para
2.7 of the EM states:
     The raising of finance generally entails a contribution to the capital
     of an entity, whether by way of money, property or services, in
     respect of which a return is paid by the entity, be it contingent
     (connoting equity) or non-contingent (connoting debt).
     It would appear that the reference to “capital” in the EM is
intended to capture the idea of “working capital” as well as capital as
recorded for balance sheet purposes.
     The unfortunate aspect of the test of “financing arrangement” is
that it appears to import an entirely colloquial understanding of the
words “to raise finance” to define what a financing arrangement is.
This colloquial use of the words “raise finance” stands in distinction
to the debt and equity tests which seek to statutorily determine, using
rigid, defined concepts, what constitutes a debt interest and what
constitutes an equity interest.
                          7. THE ENCO TEST
   The Effectively Non-Contingent Obligation (“ENCO”) test has a
number of operations under Div 974, including:
   •     being the foundation of the debt test and the primary
         determinant of a debt interest from an equity interest; and
   •     being the determinant of the “performance period” of debt
         interests for valuation purposes.
     Section 974-135 provides that an ENCO to take an action under
a scheme will exist if, having regard to the “pricing, terms and
conditions” of the scheme, there is “in substance or effect a non-
contingent obligation” to take that action. The provision explains that



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an obligation is non-contingent if it is not contingent on any event,
condition or situation including the economic performance of the
entity other than the ability or willingness of the entity to meet the
obligations. The exclusion of contingencies surrounding ability or
willingness would appear to exclude any diffidence held in the entity
to provide financial benefits or any inability due to solvency
difficulties.
     The legislation further clarifies that:
       • the mere existence of a right in the holder of an interest to
         convert the interest into an equity interest does not make
         the issuer’s obligations to repay the investment contingent.
         Accordingly, a convertible instrument can still satisfy the
         debt test;
       • a preference share is not contingent merely because of the
         legislative requirement for redemption to be met out of
         profits or a fresh issue of share capital;
       • in determining whether there is in substance or effect a
         non-contingent obligation to take an action, it is appropriate
         to have regard to the artificiality or contrived nature of any
         contingency upon which the obligation depends; and
       • an obligation is not effectively non-contingent merely
         because an entity will suffer a detrimental practical or
         commercial consequence from not fulfilling the obligation.
     A number of observations can be made regarding the operation
of this test.
7.1 Pricing, Terms and Conditions
     First, in the application of the test, the matters that should be
considered are the “pricing, terms and conditions of the scheme”.
The legislation does not explicitly state that these are the only
relevant considerations but their particular identification suggests
that they are. The reference to the “terms and conditions” of the
scheme raises consideration of the contractual elements of the


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                                                           P ABBEY

arrangements undertaken and consequently appears to be a reference
to matters of legal form. If that is so, the reference to “pricing”
appears to be the only effort to raise matters of “economic
substance” under the test.
7.2 Binding Obligations
     The ENCO test is a test of “effective” non-contingency rather
than strict legal non-contingency. The EM emphasises that it is not
only schemes which give rise to binding legal obligations which will
be effectively non-contingent: that the ENCO test is intended to
extend to a wider group of arrangements. However, the discussion in
the EM at paras 2.175 and 2.176 states that an obligation which is
not legally binding will satisfy the ENCO test if the entity is “in
substance or effect inevitably bound” to undertake an action. The
entity must be “compelled” to act.
     These statements from the EM impose a high standard and imply
that the ENCO test should really be seen as a test primarily
concerned about legal obligation rather than an extension beyond
legal obligation to economic obligation. Indeed, a conclusion
regarding satisfaction of the ENCO test will normally be founded
upon legal obligations. If the entity is not legally obliged to
undertake the action, then the EM implies that the entity must be
subject to such economic or financial pressures that it will be forced
to undertake the action (eg provide a financial benefit). Bad press,
investor dissatisfaction and fund manager criticism will not be
enough.
     The interpretation of the legislation described in the EM
emphasises that its test is founded upon non-contingency. Although
the reasons for the compulsion to act may not be strict legal
obligation, there must still be a compulsion which makes the action
not contingent.
7.3 Funding Costs
     An example provided in the EM of an ENCO which is not a
legally non-contingent obligation is where the issuer of a financing


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instrument has a right to redeem the instrument after a certain period
and in the absence of redemption is obliged to provide accelerating
returns on the instrument. In the example, the accelerating returns
would make it uneconomical for the issuer to not redeem the
instrument and so it is considered that the issuer would satisfy the
ENCO test.
     Curiously, this example is dealt with in EM again, when the
operation of the ENCO test to determine the length of the
performance period of a debt interest is discussed. In this discussion,
the EM states that it would be necessary to have regard to all of the
circumstances when considering whether a step-up in the return on a
particular interest is economically unsustainable, thereby rendering a
termination of an interest effectively non-contingent. The EM further
states that as a general rule, the level of step-up permitted by the
Australian Prudential Regulatory Authority for Tier 1 Capital
Instruments would be economically sustainable. Step-ups in excess
of this permissible step-up would be unsustainable for regulated
instruments.
7.4 Artificial Contingencies
     The extension of the ENCO test to matters of “substance or
effect” would appear to be aimed at bolstering the operation of the
legal contingency test, rather than ensuring that obligations which are
compelling for economic reasons satisfy the test. The ENCO test
aims to ensure that minor or artificial contingencies do not mean that
the debt test has failed. This is a protective measure to ensure the
debt test is not manipulated by artificial contingencies which would
allow frankable distributions to be paid on what otherwise would be
debt instruments.
7.5 Profit Testing
     The EM makes clear that a commitment to pay dividends does
not satisfy the ENCO test because the availability of profits is a
contingency. Thus, any financial benefit which depends upon the
available profits, such as the payment of a dividend on a preference



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share, will not satisfy the ENCO test. Typically then, a preference
share issue will only constitute a debt interest where: the terms of the
preference share prescribe its redemption to occur within a ten year
period; a related scheme exits which will effect a redemption or
repayment of the preference share within a ten year period; or non-
contingent returns are to be paid under a related scheme.
                            8. VALUATION
     The valuation of financial benefits is a crucial requirement to
establish the existence of a debt interest. For a debt interest to arise
under a scheme, it must be substantially more likely than not that the
value of the financial benefits provided will at least equal the value
of the financial benefits received.
     In turn, the valuation of financial benefits is dependent upon the
performance period for the relevant interest. The performance period
is the period within which “under the terms on which the interest is
issued” the effectively non-contingent obligations of the issuer to
provide financial benefits have to be met. Where the performance
period ends within ten years or less of the issue of the interest, the
financial benefits are valued on nominal terms. Accordingly, an
ENCO to return principal on an instrument within ten years of issue
will normally satisfy the debt test. Where the performance period
exceeds ten years from the issue of the interest, the financial benefits
are valued on a present value basis.
     To undertake a present value calculation of the financial benefits,
a benchmark rate of interest is established for the relevant entity and
is then discounted to 75%. The benchmark rate of interest is the
internal rate of return on an instrument issued by the entity or an
equivalent entity to a third party where that other instrument is
otherwise comparable to the instrument under consideration.
     The benchmark rate of interest is used to determine the net
present value of each financial benefit (coupon or principal return)
provided on the instrument over the course of its life. Importantly,
when calculating the value of each coupon or principal repayment, it
is to be assumed that the amount will be paid by the entity at the



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earliest time “when the entity becomes liable to pay” the amount.
This is a critical consideration. Many debt instruments will allow the
issuer to defer the payment of interest coupons, either upon the
satisfaction of certain conditions or merely at the discretion of the
issuer.9 This deferral will be ignored so long as it can be concluded
that the issuer became “liable to pay” the coupon when the periodic
payment time arose. The intent of the provisions seems to be that the
“liable to pay” requirement should be given a wide interpretation.
Under this wide interpretation, an issuer will be considered “liable to
pay” a coupon even though payment can be deferred at the issuer’s
discretion. However, if the obligation to pay the amount is subject to
a condition precedent, it may not be appropriate to say a liability to
pay exists until the condition is satisfied.
             9. OPERATION OF THE DEBT AND EQUITY
                          DISTINCTION
     As outlined above, the statutory debt and equity borderline has
been primarily instituted to determine when the return paid on an
instrument should be frankable and non-deductible or deductible and
non-frankable. The other primary operation of the debt test is to
establish the debt capital of taxpayers for the purposes of the thin
capitalisation provisions.10
     There is a range of provisions in the ITAA97 and ITAA36 which
depend upon the ownership of companies for which these provisions
are entirely irrelevant. These include:
         •    the transfer and use of losses;
         •    the membership of a consolidated group (with minor
              exceptions);
         •    the definition of public and private companies;
         •    tests for ownership and attribution under the CFC and FIF
              provisions; and


9
    Such a deferral can occur under both the Leighton Notes and the Toll RPS.
10
     Section 974-150(1) provides that scheme takes its meaning under s 995-1.

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         •    the treatment of dividends paid by non-resident entities,
              eg exemption under s 23AJ.
      The non-application of the debt and equity rules for the purposes
of dividend exemption under s 23AJ is said to arise because a
dividend qualifies for a s 23AJ exemption on the basis of whether the
relevant companies are related.11 However, this exclusion of s 23AJ
will have some curious applications. For example, where an
Australian resident company owns all of the shares in a non resident
company and is then issued a convertible note by the non-resident
company which constitutes an equity interest, any distributions paid
on the convertible note will not qualify for s 23AJ exemption even
though the relevant ownership interest will exist because the
distributions will not constitute “dividends” for the purposes of s 6(1)
of the ITAA36.
    Although the classification of debt and equity interests is
fundamentally irrelevant for the membership tests contained in the
consolidation provisions, there are two operations where the tests are
considered.
     First, where a subsidiary member of a consolidated group issues
membership interests which are classified as a debt interest, the
subsidiary member will not cease to be part of the consolidated
group. The membership interests characterised as a debt interest
(such as redeemable preference shares) will not degroup the member.
Secondly, in determining whether a company is a member of a
consolidated group, the issue of debt instruments which are classified
as equity interests will not be relevant.
     These exceptions have allowed the curious situation of a
subsidiary member of a consolidated group being able to issue a debt
instrument which is classified as a frankable equity interest. As a
result, the consolidation provisions have included specific legislation
which operates to ensure that the franking obligation of the
subsidiary member is considered to be a franking obligation of the


11
     Explanatory Memorandum to the Debt and Equity Act, para 3.13.

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head company of the consolidated group. This allows the distribution
on the equity interest to be franked.
     The residual provisions for which the debt and equity tests are
relevant include:
     •     the dividend and interest withholding tax provisions –
           amounts paid on debt interest will be subject to interest
           withholding tax while amounts paid on equity interests will
           be subject to dividend withholding tax;
     •     the foreign dividend account provisions – which will allow
           foreign dividend account credits to be applied to non share
           dividends paid by resident companies; and
     •     the foreign tax credit system – under which non share
           dividends will fall within the same basket as dividend
           income, rather than the interest income basket.
                          10. OTHER ENTITIES
     Although Div 974 only seeks to specify equity interest for
companies, the specification of debt interest applies to all entities.
The term “entity” is defined in s 960-100 of the ITAA97 and
includes individuals, partnerships and trusts.
    The wide application of the entity test has no doubt been adopted
to ensure that the thin capitalisation provisions can appropriately
apply to entities other than companies. The EM at para 2.128 states:
   The definition of a debt interest is also relevant for thin capitalisation
   purposes (see para 3.23). For these purposes the debt test is applied
   to an interest issued by any type of entity, not only companies (the
   new equity rules are limited to companies).
     However, the EM provides a confusing signal when it discusses
the deductibility of returns paid on debt interest in para 2.136:
   However, returns on interests (including debt/equity hybrids) that
   satisfy the debt test (eg an interest that would be equity interests but
   for the fact that they satisfy the debt test such as a mandatorily
   redeemable preference shares) may not be able to satisfy s 8-1


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     because they may be contingent on economic performance or may
     secure a permanent or enduring benefit for the company.
     It is not clear whether the EM intends to imply that distributions
made on debt interests issued by trusts will not be treated as
deductible for the purposes of s 25-85. Moreover, it is significant that
this provision provides that the return on a debt interest is not
prevented from being deductible under s 8-1 merely because:
  (a)    the return is contingent on the economic performance (whether
         past, current or future) of:
             (i) the entity or a part of the entity’s activities; or
             (i) a connected entity of the entity or part of the activities
                 of a connected entity of the entity; or
  (b)    the return secures a permanent or enduring benefit for the entity
         or a connected entity of the entity.
      For this provision to ensure that a distribution made by a unit
trust on a unit which is classified as a debt interest is deductible, it
would need to be concluded that the deduction would be otherwise
denied because the distribution secures a permanent or enduring
benefit for the entity, or is contingent on its economic performance.
This conclusion may be difficult to reach.
      Nevertheless, s 25-85 would appear to imply that distributions by
entities, other than companies, made on debt interests, can be
deductible. Specifically, sub-s 25-85(1) refers to “an entity” rather
than “a company” and sub-s 25-85(3) provides special rules in regard
to dividends which do not apply to returns paid on other types of
debt interests.
                             11. CONCLUSION
     This article describes merely a few of the many interpretative
issues which attend the Debt and Equity Act. There are undoubtedly
more. These issues are in many cases currently unexplored and their
resolution unclear. Nevertheless, in time the treatment of an
instrument will be disputed by taxpayers and the Commissioner



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andthe courts will be obliged to resolve these issues by interpreting
difficult and often ambiguous statutory requirements.




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