Director / Shareholder Loans – is it Debt or Equity?

Is the Loan a Debt or Equity Interest?

The Debt Equity Rules are set out in Div 974 of the Income Tax Assessment Act 1997 and apply to ‘at call’ loans made to a company by a connected entity. This may be an associate of the entity, or another member of a wholly owned corporate group, for example a controlling shareholder, that is a connected entity of the company.

A related party ‘at call’ loan, is a loan to a company, by a connected entity (controlling shareholder or director), that does not have a fixed repayment term and is repayable on demand by lender). These loans are sometimes referred to as ‘At Call’ loans.

‘At Call’ loans may be deemed as either a debt or equity interest in the company for tax purposes under the debt/equity rules, but there is a small business carve out if the company’s turnover is less than $20 million as the related party ‘at call’ loan will be treated as debt, not equity.

An ‘at call’ loan will satisfy the debt test as follows:

• Loan less than 10 years ‘at call’: if a non-contingent obligation to repay (at least) the amount borrowed, the loan will be a debt interest, irrespective of whether it pays interest.
• Loan repayable ‘at call’ with no fixed term: the loan must provide for an arm’s length interest rate to satisfy the debt test.

Why is this important?

If an ‘at call’ loan satisfies the debt test and is a debt interest:

• The interest paid by the company may be deductible (subject to use of the funds) but cannot be franked.

The Loan Agreement needs to be carefully drafted to ensure the debt test is satisfied. The company should then ensure it records a non-share capital account for tax purposes to record the related party at-call loans and any repayments by the company on those loans.

If the Debt test rules are not satisfied, the Loan will be treated as equity, which will be the case if the right to repay the loan is at the discretion of the company or the controlling shareholder who lent the funds to the company.

So, if the turnover test is not met then the ‘at call’ loan that is repayable on demand, with no fixed maximum term, interest free (or with a low interest rate), will be an equity interest for tax purposes.

In this case, the interest payable on the loan will not be deductible. However, it may be frankable but might attract the dividend substitution provisions in section 458, which are designed to prevent the distribution of profits to shareholders as preferentially taxed capital rather than dividends.

Division 7A may apply where a company pays, lends to, or forgives an amount owing by, a shareholder, former shareholder, or associate of a shareholder, of the company.

That is, the company is paying, lending or forgiving repayment of a loan in contrast to ‘at call’ loans where the shareholder lends money to the company.

If the company gets liquidated and you have lent the company money and you have not registered a security interest under a GSA, the liquidator can claw back some or all the repayments under the Corporations Act 2001 (Cth) even where the company was solvent at the time the loan or repayment was made.

If the shareholders do not register a PPSR security interest over the company, they are unsecured creditors in the event of a winding up.

Considering these risks and tax implications, any variation of Loan Agreement, whether to or from a Company, needs to be drafted carefully.

Robert Toth, Special Counsel – Accredited Commercial Law and Franchise Specialist

Sanicki Lawyers Melbourne

robert@sanickilawyers.com.au | Mobile: 0412 673 757