Australia's Income Tax Assessment Act 1936 prevents tax deductions for interest on debt where certain debt:equity ratios are exceeded. The relevant provisions, which have applied since July 1987, are known as the thin capitalization rules.
Many changes in business taxation have been suggested following the Review of Business Taxation (the Ralph Report). The government has recently announced that it will be implementing these proposals with respect to thin capitalization. While the formal amendments are yet to be released, discussions with Treasury suggest that the government intends to implement the Ralph Report proposals in full. This article describes the thin capitalization rules and the expected situation should all the proposed amendments be made.
Incentive for foreign investors to use debt
There is an incentive for foreign investors to contribute funds to their Australian investments in the form of debt rather than equity. Interest on these funds is generally deductible for Australian taxation purposes, and a tax saving is made to the extent that the interest offsets profits that would otherwise be subject to tax at the corporate rate (36%, falling to 30% over the next two years). An offsetting cost will be a 10% flat rate of withholding tax on interest paid to the foreign investor. Under Australia's imputation system, no withholding tax is payable on dividends paid to the foreign investor out of profits that have been fully subject to corporate tax. A net saving of 26% in Australian tax could be expected on profits that extracted from the Australian investment in the form of interest instead of dividends.
Thin capitalization rules
To prevent foreign multinationals allocating a disproportionate level of debt to their Australian operations, where the proportion of debt to equity in the Australian operation exceeds certain levels, the deductibility of interest payments is limited.
The structure of the Australian thin capitalization rules was described in International Tax Review's 1994 Thin Capitalization Survey. At that time, the maximum debt:equity ratio permissible was 3:1. The rules were tightened from the 1997/98 tax year when the maximum ratio was reduced to 2:1. For banks, the permissible ratio was 6:1 and has remained so. To the extent that foreign related-party debt exceeds the specified level, interest deductions otherwise allowable are denied.
Thin capitalization provisions apply to Australian investments (including companies, partnerships and trusts) made by non-resident entities. They only apply where there is a foreign controller of the Australian entity. A non-resident is a foreign controller in the case of an investment in an Australian company if it, and its associates, together:
control 15% or more of the votes in the company;
are entitled to receive 15% or more of dividends or distributions of capital;
are capable of gaining that level of control or entitlement; or
the Australian company or its directors are obliged or accustomed to act in accordance with the directions, instructions or wishes of the non-resident.
Resident company groups (ie with a common Australian holding company) are generally consolidated and treated as a single entity for thin capitalization purposes. The thin capitalization rules also apply to foreigners investing directly in Australia (eg via a branch operation).
Debt versus equity
In distinguishing debt from equity, Australian courts have focused on the form of the relevant instrument rather than its substantive effect. This distinction is largely maintained in the thin capitalization rules.
Debt
Debt is defined as amounts owing by the company on which interest is payable by the company that would otherwise be deductible. Only foreign debt is included for calculation of the debt:equity ratio. Until recently, this was further limited only to debt owed to the foreign controller or foreign associates of the foreign controller of the Australian entity. This did not include debt owed to any other foreign party.
However, in the 1997/98 tax year, the measure of foreign debt was changed to include debt to unrelated overseas parties which is guaranteed by or secured against the assets of the foreign controller or its non-resident associates, unless the debt could be obtained from arm's-length sources without the guarantee or security.
This avoids the previous problems of debt being shifted out of the thin capitalization calculation by having the debt issued by parties other than the controller.
Equity
The debt:equity ratio for the thin capitalization calculation refers to equity of the Australian entity from foreign sources. Local investment is excluded.
Foreign equity includes the total direct interest of the foreign controller or its non-resident associates in the Australian company's share capital, reserves and unappropriated profits (less accumulated losses). This amount is reduced by amounts loaned back to the foreign controller or its non-resident associates but is not reduced by short-term credit from export of goods and services, certain financial institution credits or certain debentures.
Tracing provisions exist in the determination of which parties are foreign controllers and which non-resident parties are their associates. The sum of the direct interests of each of these parties is included in the calculation. Equity interests held by foreign companiesthat are not associates are not aggregated even if one of those foreign companiesx has an interest in the other but insufficient for the companies to be associates.
Similar provisions apply for Australian partnerships and trusts, based on a foreign controller or associate's fixed interests in the partnership or trust. Income or capital of a trust subject to discretion is excluded. Provisions dealing specifically with partnerships and trusts have been effective since 1997/98. Before that time, partnerships and trusts were dealt with as direct investments.
Capital maintenance
Share capital is measured at the end of the income year. Profits and reserves are calculated at the start of the tax year. To adjust for this, the total of these amounts is reduced by the level of accumulated profits capitalized by share issues during the year. Measurement at the end of a year allows short-term equity injection near the end of the tax year to permit a higher equity component for the purposes of the debt:equity calculation. Payment of dividends could occur before the end of a tax year, but would reduce the level of equity for the following year. Asset revaluations only increase equity levels in the following tax year.
To prevent planning via equity injection, capital maintenance provisions exist. If certain foreign equity is invested in a particular year of income but ceases to be held during the subsequent two-year period from the end of that year of income, clawback provisions operate. The level of foreign equity to be taken into consideration in the calculation for that previous year of income is reduced.
Anti-avoidance provisions
Certain other provisions existed previously that limited transfers to and from share premium accounts and referred to the paid-up value of shares. When the Corporations Law abolished the concept of par value for shares, these provisions were amended.
Other previous provisions addressed the issue of a foreign controller avoiding the thin capitalization provisions by lending to a foreign bank not associated with the group, which would in turn lend to the Australian subsidiary. In 1997 these specific provisions were repealed, as the general anti-avoidance provisions contained in the Income Tax Assessment Act 1936 were considered more appropriate to deal with the issue. The provisions ceased to be effective in the 1997/98 tax year.
Current reforms
While the above outlines the present situation with respect to thin capitalization, various changes are in the pipeline. In November 1999, the Treasurer announced that proposals from the Ralph Report would be implemented.
Changes to the application of thin capitalization rules
Under these proposals, the control test is to be aligned with the control test used for controlled foreign companies (CFCs). The threshold for foreign control of a CFC is 50% (or 40% where there is no other person with the ability to control). To be consistent with this approach, the test for foreign control for thin capitalization purposes is to rise from 15% to 50% (40% where no other party has control).
While most foreign-owned investments are majority owned and will remain foreign controlled under these proposals, foreigners who hold between a 15% and 50% interest in the Australian operation will no longer be subject to the rules and will not be restricted in their level of debt finance.
Changes to debt
Debt curently only includes foreign debt held directly by the foreign controller or its foreign associates, or third-party foreign debt that is guaranteed or secured by the foreign controller or its foreign associates. The Ralph Report suggests that this measure is too narrow and proposes to extend the measure of debt to the total debt of the Australian party.
The term "total debt" includes third-party debt irrespective of whether it is guaranteed or secured by the foreign controller or its associates. This is a significant extension of the thin capitalization provisions. Third-party debt is now unlimited so long as such borrowings do not require the support of the foreign controller. Under the new proposals, even debts which are from unrelated parties will be included.
Not only does the term "total debt" extend the measure of debt to debt owing to third parties, but the former requirement for debt is also removed. All debt, including debt from local sources, is included in the calculation.
For example, consider the case of a foreign controller who has A$2 million of equity in an Australian entity. Assume the Australian entity has borrowed A$3 million from unrelated parties without any support from the foreign controller. The foreign controller could invest up to a further A$4 million in interest-bearing debt in the Australian entity without breaching the 2:1 maximum debt:equity ratio. Using the same example, under the proposed methodology, the total debt of $7 million is included. The debt:equity ratio is now 7:2, exceeding the permitted ratio.
Increasing the permissible ratio As the measure of debt is expanded, the 2:1 debt:equity ratio is far more likely to be breached. Thus, the applicable ratio is to be relaxed to 3:1. This is a safe harbour, so no matter whether or not this can be supported on an arms's-length basis, if the level of debt is below the 3:1 ratio, deductions on interest payments will be allowed.
The current 6:1 ratio for financial institutions is to be abolished and replaced with the same 3:1 safe harbour ratio, but with addition of an "on-lending rule" which disregards debt that is on-lent by a financial institution. However, to prevent excessive on-lending, a maximum gearing limit (including all debt, even debt that is on-lent) is applied. This maximum limit is 20:1.
Some financial institutions are subject to capital adequacy rules through the Australian Prudential Regulatory Authority. It is proposed that the above new rule for financial institutions should not apply to such bodies, but instead alternative safe harbour rules are to be devsed based on the capital levels required to be reported for regulatory purposes.
Where the ratio is breached, but deductions are permitted
Depending on the Australian business, it is foreseen that entities may be able to borrow in excess of the 3:1 ratio on an arm's-length basis. A further test is to be applied under which deductions will still be allowed if the level of total debt is borrowed on an arm's length basis or could have been borrowed on an arm's-length basis (ie with no parent company support). Even if this arm's-length test is not satisfied a further test is available based on the group's worldwide gearing.
The test is whether the gearing of the Australian investment is not greater than 120% of the worldwide gearing level of the group. If the gearing is equal to or less than 120% of the worldwide gearing level, the test is passed even if the gearing is in excess of the 3:1 ratio and could not be supported in arm's-length transaction.
The rationale for the alternative test is that if the Australian party's gearing is in line with worldwide gearing levels, it is considered that the group is not shifting excessive debt to its Australian operations, hence Australia is not incurring a disproportionate level of interest deductions.
Impact of a total debt measure down the corporate chain
Under the proposals, the thin capitalization equation includes debt from both foreign and local sources. Where an Australian subsidiary borrows from another Australian member of the foreign controlled group, under the new proposals, this amount will be included in the total debt measure unless the companies are consolidated, which then requires 100% common ownership.
If the debt:equity ratio is exceeded, interest deductions by this entity will be denied. The Australian party loaning the money will still receive this amount as interest, and will be assessed on this income. If the lender has itself borrowed the funds from a foreign-controlled holding company, a further interest deduction will be lost.
For foreign ventures operating in multiple tiers or with holding companies, interest deductions on the same sum of money may be lost while interest income is still subject to tax. The government is looking at ways of consolidating non-wholly-owned groups so as to avoid deductions being denied unfairly.
Time frame for reform implementation
The proposals are to be effective July 1 2001. No special transitional provisions are proposed. In the first year of operation, the thin capitalization test is to be applied at the end of the tax year. The government proposes that this will provide sufficient time for business restructuring or for companies to reduce debt levels.
Foreigners investing in Australia generally set up their investment structure upon entry into the Australian market. This structure is based on the legal framework at that time and is expected to remain as such for many years. The proposals do not allow for any grandfathering of current debt structures. Hence, structures established under the current regime may be adversely affected under these changes. Foreign investors need to factor in the effect of the changes. This can be difficult in areas that are unresolved, such as non-wholly-owned groups.
