Understanding the New Thin Capitalisation and Debt/Equity Rules for Australian and Foreign Entities
The new thin capitalisation and debt/equity rules applying to all Australian and foreign entities (with a presence in Australia) from 1 July 2001 have the potential to affect existing financing arrangements. Under these tax changes, entities may no longer be entitled to the current level of deductions for borrowings. As a matter of urgency, taxpayers should review new and existing funding arrangements to ensure that the intended tax treatment of such arrangements is achieved.
Set out below is a general overview of the new rules. This is a summary only and taxpayers should obtain specific advice regarding the applicability of the new thin capitalisation and debt/equity rules to their particular circumstances.
Debt and equity
Under the new rules, the test for distinguishing debt interests from equity interests focuses on economic substance rather than on legal form. Broadly, holders of an equity interest in a company are those who hold interests which provide returns contingent upon the economic performance of the company (unless their only interest in the company is a debt interest). A debt interest is one which, at the time of its issue, imposes on the entity an effectively non-contingent obligation to pay an amount to an entity which is at least equal to the amount issued.
The new rules apply generally to the taxation of interest payments and of dividends (including imputation), thin capitalisation (refer below), treatment of payments to non-residents and withholding tax. They are not intended to apply to provisions relating to ownership of companies (eg. loss transfer provision), certain leases, derivatives, royalties and employment contracts.
Timing for debt/equity rules
The new debt/equity rules will apply from 1 July 2001. However, under certain transitional measures, an issuer of a relevant debt or equity interest will generally have the current law continue to apply until 1 July 2004 if the relevant interest was issued before 1 July 2001. However, an election to have the new rules apply from 1 July 2001 may be made in writing and lodged with the Commissioner within 90 days of Royal Assent of the new debt/equity rules or within such further time as the Commissioner allows.
As a further transitional measure, certain 'at call' loans (that might have been entered into on a non-arm's length basis) will give rise to a debt interest and not an equity interest in a company until 1 January 2003.
Thin capitalisation
Broadly, the rules disallow debt deductions (such as interest and discount) to the extent that the average debt for the year exceeds the maximum allowable debt. The new thin capitalisation rules limit the deductions relating to the total debt (rather than only the foreign debt as under the current regime) used to finance Australian operations of both inward investing and outward investing entities.
There are separate regimes for inward investing entities (foreign entities with Australian investments) and outward investing entities (Australian entities with offshore investments). Within these two regimes, there is variation of the rules depending on whether an entity is Australian, foreign, an authorised deposit taking institution (ADI), a general investment vehicle or investor or a financial investment vehicle or investor.
Entities subject to the new rules include companies, trusts, partnerships and individuals. Significantly, Australian controllers of foreign entities and Australian entities that carry on business overseas through a permanent establishment are also subject to the new thin capitalisation measures. A deminimis concession prevents the regime from applying where the debt deductions of a taxpayer and its associates do not exceed $250,000 in a year of income.
Timing for thin capitalisation rules
The new thin capitalisation rules will apply from a taxpayer's first income year commencing on or after 1 July 2001. The rules will generally apply to the average value of debt capital and other relevant values. However, as a transitional measure, in the first year of application of the new thin capitalisation rules, taxpayers may rely on year-end values for assets, debt capital and other relevant values rather than the average of these values over the year. This provides taxpayers with an opportunity to restructure their funding prior to the end of the taxpayer's first income year commencing on or after 1 July 2001.
Implications for various types of entity
Inward investors
In general terms, for inward investments, debt deductions are disallowed if the average value of all the debt capital of an entity that gives rise to its deductions for a year exceeds its maximum allowable debt. The maximum allowable debt for an inward investor, that is not an ADI or a financial entity, is the greater of the safe harbour debt amount and the arm's length debt amount.
The safe harbour debt test broadly requires that the amount of debt not exceed 75% of the entity's Australian assets and is informally described as a debt to equity ratio of 3:1. If the average value of the entity's debt capital exceeds its safe harbour debt amount, it must satisfy the arm's length debt test in order to avoid being denied some or all of its debt deductions.
The arm's length debt amount is calculated on the basis of various factual assumptions and a number of relevant factors listed in the rules. This test is designed to determine whether the entity has a reasonable amount of debt in its particular industry.
Inward investors
In general terms, for inward investments, debt deductions are disallowed if the average value of all the debt capital of an entity that gives rise to its deductions for a year exceeds its maximum allowable debt. The maximum allowable debt for an inward investor, that is not an ADI or a financial entity, is the greater of the safe harbour debt amount and the arm's length debt amount.
The safe harbour debt test broadly requires that the amount of debt not exceed 75% of the entity's Australian assets and is informally described as a debt to equity ratio of 3:1. If the average value of the entity's debt capital exceeds its safe harbour debt amount, it must satisfy the arm's length debt test in order to avoid being denied some or all of its debt deductions.
The arm's length debt amount is calculated on the basis of various factual assumptions and a number of relevant factors listed in the rules. This test is designed to determine whether the entity has a reasonable amount of debt in its particular industry.
For an inward investing financial entity, a safe harbour gearing ratio of 20:1 will apply to the entity's whole business. The safe harbour debt ratio of 3:1 will only apply to the financial entity's non-lending business. Again certain further considerations will apply where financial entities are engaged in certain securities repurchase arrangements.
Outward investors
Broadly, for an outward investing entity, which is not an ADI or a financial entity, excess debt is the amount by which its adjusted average debt (total debt capital reduced by loans to controlled foreign entities) exceeds its maximum allowable debt. The maximum allowable debt is the greatest of, the safe harbour debt amount, the arm's length debt amount and the world wide gearing debt amount.
The safe harbour debt amount is broadly 75% of the Australian assets of a general entity. For an outward investing financial entity, the safe harbour amount represents a debt to equity ratio of 20:1 in relation to the Australian activities. A 3:1 debt to equity ratio applies in relation to the financial entities non-lending activities.
The arm's length test is similar to that for inward investment discussed above. The world wide gearing debt amount permits the gearing of an entity's Australian operations to be up to 120% of the gearing of the entity's worldwide operations. However, this test is not available if the Australian entity is itself controlled by foreign entities.
Authorised Deposit-taking Institutions
A separate regime applies to foreign ADIs that carry on business at or through Australian permanent establishments (such as foreign bank branches) and to Australian resident ADIs that control foreign entities (including foreign permanent establishments).
Debt deductions may be disallowed if a minimum amount of equity capital is not maintained. For foreign ADIs, the minimum amount of equity capital is the lesser of the safe harbour capital amount and the arm's length capital amount. The safe harbour capital amount is 4% of adjusted Australian risk-weighted assets. The arm's length capital amount is determined in a similar manner to the arm's length debt amount for non-ADIs.
For resident ADIs, the minimum amount of equity capital for outward investing ADIs is the least of the safe harbour capital amount, the arm's length capital amount and the worldwide capital amount.
Groups
Entities may be able to choose to have the thin capitalisation measures apply to them as a group.
