As discussed in the previous update, the Australian government has set up a committee to report on the reform of Australia's business tax system. The reforms considered in relation to interest deductibility from an international perspective are summarized below.
Deductibility of interest for offshore investments
The committee suggests that for non-portfolio investments, it may be justifiable to deny a deduction for interest where an Australian group has interests in controlled non-resident entities and/or foreign branches and there is "strong evidence" that the Australian revenue is bearing an undue proportion of the interest expenses. The Committee proposes:
a general rule that a deduction for interest be denied to the extent that the gearing of the group's domestic investments exceeds a fixed ratio; and
that where that ratio is exceeded, a deduction would be allowed if the group could demonstrate that Australian gearing was consistent with the gearing of global operations. An arm's length test would be used to determine whether the gearing level was higher than that which would be expected in a comparable independent operation.
For foreign portfolio investments by entities and offshore investments by individuals, the committee suggests that the existing rules for allocating interest expense between classes of income continue to apply.
Thin capitalization
The committee suggests that Australia's thin capitalization provisions are not fully effective in preventing excess gearing of Australian operations by foreign multinationals. The following two options are discussed.l World-wide group gearing: under this proposal, interest deductions would be allowed where gearing does not exceed the level of the gearing of the global operations. If that level is exceeded, an arm's-length test would determine whether the gearing level of the Australian operations is higher than that which would be expected in a comparable independent operation.
l Apply a fixed gearing ratio: if the fixed gearing ratio is exceeded then, as in the first option, an interest deduction would be allowed up to the level of gearing of the global operations. An arm's length test may also apply to this option.
Under both options, Australia's debt creation rules would be repealed. The committee does not indicate what an appropriate safe harbour gearing ratio might be and does not comment on the adequacy of the general 2:1 ratio. The committee considers that the 15% foreign control threshold for the application of the thin capitalization provisions could be increased. The required level of control, however, is not canvassed.
Ian Kellock
