2. The thin capitalisation mischief
High debt to equity ratio – highly geared
Larger than normal debt costs
Enables multinational groups to shift profits to lower
taxed regimes
3. The general response
Limit debt deductions for domestic borrowings from
offshore associated entities
Generally ignore arm’s length and non-cross border
arrangements
4. Two approaches
Statutory limit based on gearing ratio
Most common
Easy to apply but inflexible
Limit based on estimate of arm’s length debt amount
Rarely used, most often as fallback to statutory limit
Difficult and expensive to apply but has potential to give
accurate reflex of real world conditions.
5. An underlying condition
Debt capital held by domestic entity is applied to the
domestic business
Not deductible otherwise?
Prerequisite to fall under thin capitalisation rules
Neither of these conditions apply to Australian tax
regime.
6. Australian regime
Broader application of thin capitalisation rules.
Inward investors
Outward investors
Outward investors – potential to maximise NANE
profits from non-portfolio holdings in o/s subsidiaries.
Section 25-90 allows debt deduction
7. Australian methods
‘Safe harbour’ statutory limit based on a fixed
debt:equity ratio.
Fall backs if average debt is greater
Worldwide gearing based on gearing of worldwide group
Arm’s length debt – the amount of debt the Australian
business entity ‘would have held’.
8. The general case
Debt capital is applied to Australian business
Investment decision has been made
Question is whether level of debt is sustainable
Arm’s length debt analysis focuses on the amount of
debt an arm’s length lender would advance
No need for consideration of the investment decision.
9. The exception
Taxpayer is an Australian resident outward investor
Borrowings are at arm’s length
Funds are applied to purchase of non-portfolio
interests in overseas companies
10. The mischief
Dividend income derived from application of debt capital
is NANE in the hands of the Australian head company (s.
768-5 of the ITAA 1997)
Deductions for expenses of debt capital incurred by the
Australian head company are allowed (s. 25-90 of the ITAA
1997)
As debt deductions increase, Australian profit is effectively
shifted from taxable Australian income to NANE
11. The question
Do the existing arm’s length debt provisions
adequately deal with this situation?
Two supplementary questions:
Are they intended to restrict deductions?
(If so) are they effective?
12. Policy intent
‘... The thin capitalisation requirements will be the only restriction on the
deductibility of interest where Australian taxpayers borrow for investment in
controlled foreign entities.’
Review of Business Taxation Final Report page. 664
‘Debt deductions will, in certain instances, no longer be denied to taxpayers
because they were incurred in earning exempt foreign income. These debt
deductions, provided they are otherwise allowable under the general deduction
provisions, will come within the scope of the thin capitalisation regime when
determining the amount to be allowed.’
Explanatory Memorandum to The new Business Taxation
(Thin Capitalisation) 2001 Bill, Paragraph 1.99
13. The law (1)
Arm’s length debt amount is notional amount of debt
capital that would be:
Held by the taxpayer, and
Loaned to the taxpayer
in arm’s length arrangements
Subject to seven assumptions
Taking into account twelve factors
14. The law (2)
Assumptions are broadly that the entity carried in the
Australian business in isolation with no access to
assets or credit support from overseas members of the
group.
Factors all relate to capacity service debt, only a few
related to investment decisions.
15. Application – ATO guidance
TR 2003/1 Income tax: thin capitalisation - applying
the arm's length debt test
6 step methodology.
Focus on capacity to service debt
16. Two stumbling blocks
There is an underlying assumption that the debt held by the
taxpayer is applied to the Australian business
‘The new thin capitalisation regime ... limits deductions relating to the
total debt of the Australian operations ...’ Paragraph 1.14 of the EM to The
New Business Tax (Thin Capitalisation) Act 2001 (emphasis added).
law and guidance are predicated on this.
Extreme difficulty in establishing and validating a hypothetical
debt financed investment in the Australian business.
Leads to incomplete analysis of the amount of debt the
Australian entity would hold.
17. The upshot
Focus is entirely on the Australian taxpayer’s capacity
to service the debt – the debt an arm’s length lender
would allow.
Taxpayers have been able to claim deductions for debts
that have been entirely applied to purchase of overseas
subsidiaries.
Contrary to stated policy, thin capitalisation rules have
failed to limit these deductions.
18. The remedy
Limit the amount of debt worked out using the arm’s
length method to the amount actually applied to the
Australian business.
Add a subparagraph to the description of the notional
debt amount the taxpayer would hold (paragraph 820-105(1)(a)):
(iv) does not exceed the amount of debt capital actually applied to the entity’s
Australian business as mentioned in subsection (2)
Would not prevent application of the statutory limit
that gave the best result.
