What is Thin Capitalisation?
Thin capitalisation is a financial practice involving the funding of subsidiaries with a higher proportion of debt relative to equity than is typical in an arm’s length financial arrangement.
This practice is often employed for tax related purposes. Specifically, it involves a company, often based in one jurisdiction, providing funding to its subsidiary in another jurisdiction through an increased amount of debt, aiming to reduce the subsidiary’s taxable profits by claiming excessive interest deductions.
This is achieved by funding their Australian operations with a significant amount of debt and relatively little equity, which can lead to profit shifting out of the country.
The primary objective of these rules is to prevent multinational enterprises from manipulating their finances to reduce their taxable income in Australia.
How Thin Capitalisation Works
Thin capitalisation rules work by limiting the deductions a company can claim for interest expenses and borrowing costs, collectively known as debt deductions. These limitations come into effect when the debt to equity ratios of a company exceed specific prescribed debt limits.
To maintain the integrity of these rules, the arrangements where companies artificially inflate the maximum allowable debt limit are closely examined as per laws.
This prevents them from keeping their debt artificially high to reduce their taxable income.
Special Attention to Debt Interest Manipulation
Tax officials also pay special attention to situations where a particular financial instrument called debt interest is used to manipulate the amount considered as debt capital for thin capitalisation purposes. This can be a way for companies to reduce their apparent debt levels for tax purposes.
In determining a company’s debt capital, these rules require it to be valued in accordance with accounting standards. The specific classification of the debt is not the deciding factor; what matters is the adherence to accounting standards in this valuation process.
What are Debt Deductions?
A debt deduction refers to costs incurred in connection with a debt interest that would typically be tax deductible. This includes expenses like interest payments, discounts on securities, and certain fees.
However, certain costs such as foreign currency losses, salary or wage payments, and rental expenses are not considered as part of these deductible debt deductions.
Importantly, any debt deductions that are disallowed under the thin capitalisation rules cannot be utilized to increase the cost base of a Capital Gains Tax (CGT) asset. This means that these deductions cannot be carried over or utilized for other tax benefits.
Entities Affected by Thin Capitalisation Rules
The thin capitalisation rules have implications for various types of entities, which include companies, trusts, partnerships, and unincorporated bodies.
Let’s break down the key categories of entities that may be subject to these rules:
Australian Entities That Are Foreign Controlled
This category involves Australian based entities that are under foreign control, meaning they have significant ownership or influence from foreign interests. Typically, these are Australian companies, trusts, or partnerships controlled by foreign entities.
Foreign Entities with Australian Interests
Foreign entities that have direct investments in Australia or conduct business operations through a permanent establishment in Australia fall under the scope of the thin capitalisation rules. These entities are often foreign companies or businesses operating within Australia.
Australian Entities with Overseas Interests and Associate Entities
Australian entities that exercise control over foreign entities or engage in business operations through permanent establishments abroad and associate entities may also be subject to these rules.
This category includes Australian companies, trusts, and partnerships with overseas interests or affiliations.
Explanation of the Definition of Australian Entity
The definition of Australian entity is designed to primarily affect companies, trusts, and partnerships, rather than unincorporated bodies. The rationale for this distinction is as follows:
Foreign Controlled Australian Entity
A foreign controlled Australian entity can only be a foreign controlled Australian company, trust, or partnership. In other words, if a foreign entity has significant ownership or control over an Australian entity, that entity will most likely be a company, trust, or partnership.
Australian Controlled Foreign Entity
An Australian controlled foreign entity can only be a controlled foreign company, trust, or corporate limited partnership. This means that when an Australian entity exercises control over a foreign entity, it is typically in the form of a company, trust, or corporate limited partnership abroad.
Special Treatment for Australian Branches of Foreign Banks and Non Bank Financial Entities
An interesting aspect to note is that an Australian branch of a foreign bank or a foreign non bank financial entity can be considered as part of a group’s head company or treated as part of a single resident company for the purpose of determining their thin capitalisation position.
This means that the branch is treated as a separate entity from the entity that owns the branch, similar to how a subsidiary operates within a larger corporate structure.
Entities Exempt from Thin Capitalisation Rules
The thin capitalisation rules contain exemptions for specific entities and situations where these rules do not apply. Following are the entities that are not subject to these rules:
Private or Domestic Assets and Liabilities
The thin capitalisation rules do not apply when the assets and liabilities under consideration are primarily private or domestic in nature.
In other words, if the financial arrangements are predominantly related to non commercial or non international dealings, these rules are not enforced.
Taxpayers Falling Below De Minimis Threshold
Taxpayers and their associates are exempt from these rules if they claim total annual debt deductions, such as interest expenses, that do not exceed a specified de minimis threshold.
The threshold is currently set at $2 million. Essentially, if the amount of interest deductions falls below these thresholds, the thin capitalisation rules are not applicable.
Outward Investing Australian Entities with Predominantly Domestic Operations
Australian entities that primarily engage in outward investing activities and whose average Australian assets and those of their associates make up 90% or more of the total assets (including those of their associates) are not subject to the thin capitalisation rules.
This exemption is intended to benefit entities whose operations are concentrated in Australia, where the vast majority of their assets and activities are domestic.
Special Purpose Entities Managing Economic Risk
Special purpose entities that are established for the specific purpose of managing economic risk associated with assets, liabilities, or investments and meet certain criteria are exempt from these rules.
To qualify for this exemption, at least 50% of the entity’s assets must be funded through debt interests, and the entity must be structured to be insolvency remote. This exemption is designed to accommodate special purpose entities involved in financing arrangements, such as those used in social infrastructure Public Private Partnerships.
Thus, all these exemptions aim to strike a balance between tax regulation and promoting certain types of economic activity.
Application of Thin Capitalisation Rules
The way the thin capitalisation rules apply depends on several factors. These include:
- the nature of the entity,
- whether it is inward investor or
- outward investing entity, and
- whether it falls into the category of an authorised deposit taking entity (ADI),
- a financial entity, or
- a general entity.
Here’s a breakdown:
Inward Investors vs. Outward Investing Entities
The application of thin capitalisation rules varies based on whether the entity is an inward investor, meaning it is controlled by non residents, or an outward investing entity, indicating it has investments located offshore.
Types of Entities:
Entities fall into different categories based on their financial activities. These include:
- Authorised Deposit Taking Entities (ADI): These are entities authorized to take deposits from the public, typically banks and similar institutions.
- Financial Entities: These are entities that engage in financial activities but are not ADIs.
- General Entities: Entities that do not fall into the categories of ADIs or financial entities.
Financial entities that are not ADIs have the option to choose to be treated as ADIs for the purpose of thin capitalisation rules. This election allows them to follow the rules applicable to ADIs, which might offer certain advantages or flexibility.
In cases where an entity exhibits both inward and outward investing characteristics, such as a foreign controlled Australian resident entity that exercises control over a foreign entity, the rules applicable to outward investing entities are typically enforced.
This is to ensure that the rules align with the entity’s primary nature and activities.
Thin Capitalisation Rules For ADIs
For ADIs, which primarily include banks, the thin capitalisation rules come into play when the equity capital used to finance their Australian operations falls below a specified minimum equity requirement.
The application of these rules differs for inward investing ADIs and outward investing ADIs:
Inward Investing ADIs (Foreign ADIs with Australian Permanent Establishments):
For foreign ADIs with Australian permanent establishments, the minimum amount of equity capital is determined as the lesser of two key measures:
- Safe Harbour Capital Amount: This is calculated as 6% of Australian risk weighted assets (or 4% for income years before 1 July 2014). It sets a baseline for the minimum equity capital required for these ADIs.
- Arm’s Length Capital Amount: Similar to how arm’s length debt amounts are determined for non ADIs, this figure is calculated based on what would reasonably be expected to be the entity’s minimum arm’s length capital funding for its Australian business throughout the year.
Outward Investing ADIs (Australian ADI Entities with Foreign Investments):
Outward investing ADIs must meet specific equity capital requirements, which include matching capital with certain other Australian assets. The minimum equity capital for outward investing ADIs is determined as the lesser of three factors:
- Safe Harbour Capital Amount: This is calculated as 6% of the Australian risk weighted assets. It sets the baseline equity capital requirement.
- Arm’s Length Capital Amount: Similar to the inward investing ADIs, this figure is a notional amount representing what would reasonably be expected to be the bank’s minimum arm’s length capital funding for its Australian business throughout the year.
- Worldwide Capital Amount: This factor allows Australian ADIs with foreign investments to fund their Australian investments with a minimum capital ratio equal to 100% of the Tier 1 capital ratio of their worldwide group. This considers the capital strength of their broader global operations.
Thin Capitalisation Rules For Non ADIs
For non ADIs, which are entities other than authorised deposit taking institutions (such as banks), the thin capitalisation rules are designed to reduce debt deductions when the amount of debt used to finance the entity’s Australian operations surpasses a specified maximum.
The application of these rules varies based on whether the entity is a financial institution and whether it is an inward or outward investing entity.
Inward Investing Non ADI Foreign Entities with Australian Investments
Inward investing foreign entities with Australian investments determine the maximum allowable debt based on the greatest amount calculated under three tests:
Safe Harbour Debt Test
This test considers debt as excessive if it exceeds the safe harbour gearing limit of 1.5:1.
For financial entities, the safe harbour gearing ratio applies only to their non lending business. Debt used for lending to third parties or similar activities is excluded from the calculation under an on lending rule.
An additional safe harbour gearing ratio of 15:1 applies to the total business of financial entities.
Special rules accommodate higher allowable gearing ratios for financial entities with assets that can be fully funded by debt. Assets and liabilities are determined following accounting standards.
Arm’s Length Debt Test
This test involves an analysis of the entity’s activities and funding to determine a notional amount representing the maximum arm’s length debt funding of its Australian business during the period.
Worldwide Gearing Debt Test
This test applies to inward investors, including those with outward investments. It does not apply if the entity’s statement of worldwide equity or assets is nil or negative, or if audited consolidated financial statements do not exist.
Additionally, the entity must meet an asset threshold, meaning that Australian assets must represent no more than 50% of the consolidated group’s worldwide assets.
The application of this test is optional, meaning that if another test (like the safe harbour test) indicates that the entity has not exceeded its maximum allowable debt, there’s no need to apply the worldwide gearing debt test.
Outward Non ADI Australian Entities with Foreign Investments
Outward investing Australian entities with foreign investments determine the maximum allowable debt based on the greatest amount calculated under the same three tests: safe harbour, arm’s length, and worldwide gearing.
The first two tests are quite similar to those for inward investors, but they consider the investment made by the Australian non ADI in controlled foreign entities.
Worldwide Gearing Debt Test for Outward Investors
This test allows Australian entities with foreign investments to fund their Australian investments with gearing of up to 100% of the gearing of the worldwide group they control. However, this test is not applicable if the Australian entity itself is controlled by foreign entities.
Amendments to thin capitalisation rules
The Australian government is in the process of introducing significant changes to the country’s thin capitalisation rules. Some of the key points include:
Replacement of Asset Based Rules: The existing asset based thin capitalisation rules are set to be replaced with new earnings based rules. This change reflects a shift from evaluating capital adequacy based on assets to a focus on earnings.
Introduction of a New Arm’s Length Debt Test: The proposed changes also introduce a new measure in the form of a third party debt test. This test aims to ensure that the debt used by entities complies with arm’s length principles, making it fair and reasonable.
The amendments are set to take effect for income years commencing on or after 1 July 2023.
The primary motivation behind these amendments is to address risks to the domestic tax base caused by the excessive use of debt deductions, particularly by multinational enterprises.
By shifting the focus to earnings and introducing an arm’s length debt test, the governent aims to enhance the integrity and transparency of the tax system and ensure that multinational entities pay their fair share of taxes in Australia.
Interaction of Thin Capitalisation Rules with Other Taxing Provisions
The thin capitalisation rules in Australia don’t exist in isolation; they interact with various other taxing provisions.
Under the thin capitalisation rules, a fundamental distinction is made between equity interests and debt interests as per tax laws. This distinction is crucial when determining the impact of thin capitalisation on an entity’s tax position.
If related schemes result in a debt interest and involve a hedging scheme, such as an interest rate swap used to hedge a loan, it’s noteworthy that the presence of this hedging scheme is disregarded when calculating debt interest for thin capitalisation purposes.
For practical purposes, this means that any losses incurred in relation to the hedging scheme are not considered as debt deductions under tax laws. This provision ensures that the impact of derivative financial arrangements, such as hedging schemes, on a company’s debt deductions is appropriately accounted for.
Transfer Pricing Provisions
The thin capitalisation rules are not immune to the transfer pricing provisions. Even if a taxpayer complies with the safe harbour debt limit, their eligibility for certain deductions can still be subject to adjustments or even denial under the transfer pricing provisions.
Transfer pricing rules come into play when related entities engage in transactions, and the terms of those transactions are not on an arm’s length basis.
The rules aim to ensure that transactions between related parties are priced fairly, as if they were unrelated parties, and do not result in the shifting of profits to reduce tax liability.
This interaction ensures that entities cannot bypass the arm’s length principles by leveraging thin capitalisation provisions.
When it comes to consolidated or MEC (Multiple Entry Consolidated) groups that incorporate one or more Authorised Deposit Taking Institutions (ADIs), there are specific considerations. If all ADIs in the group happen to be specialist credit card institutions, certain exemptions or variations to the thin capitalisation rules may apply.
For instance, the head company of a consolidated group can apply the thin capitalisation rules as if the group didn’t contain any ADIs if all ADIs in the group are specialist credit card institutions. However, it’s crucial to note that this exemption doesn’t apply when all ADIs in the group are specialist credit card institutions.
Additionally, special considerations apply when the head company of a consolidated group or a single Australian resident company (which cannot consolidate) opts to treat the Australian permanent establishments of a foreign bank as part of itself.
In this scenario, the way the thin capitalisation rules are applied may vary depending on whether any of these entities are ADIs and specialist credit card institutions.
Anti Avoidance Measure for Double Gearing Structures
An anti avoidance measure addresses double gearing structures.
This measure lowers the threshold for determining associate entity debt, associate entity equity, and the associate entity excess amount for interests in trusts and partnerships from 50% or more to 10% or more.
The purpose is to prevent foreign investors from using complex structures involving multiple flow through entities to convert trading income into more favorably taxed interest income.
Accounting Standards Compliance
Entities must adhere to accounting standards when determining the value of their assets, liabilities (including debt capital), and equity capital. They must use the values as presented in their financial statements and are not allowed to revalue assets specifically for thin capitalisation purposes.
Treatment of Certain Tax Consolidated Groups
Non ADI foreign controlled Australian tax consolidated groups and multiple entry consolidated groups with foreign investments or operations are treated as both outward investing and inward investing entities for tax purposes.
This recognition aligns with their complex structure involving foreign investments and operations.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.