The new law in brief

An important Bill affecting foreign investors into Australia was passed by the Australian Parliament, 25 September 2014, – the ‘Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014’.

It affects two areas of taxation in Australia – tax deductibility of financing expenses in an international context, and the taxation of dividends in Australia received from abroad.

This note deals with the tax deductibility of financing expenses – the so-called ‘thin cap’ rules. (It does not deal with the thin cap rules applicable to financial entities and banks).

Thin cap rules – generally

‘Thin cap’ is short for ‘thin capitalisation’. A company is thinly capitalised if its debt is excessive compared to its equity. A foreign-based group with a subsidiary in Australia would often prefer to finance its Australian subsidiary with as much debt as possible, in order to maximize the amount of interest expense, on the basis that interest is usually tax deductible.

The usual alternative, financing by way of injecting share capital, does not give rise to any form of expense.

With Australian corporate tax rates at a flat 30%, it is often the case that paying interest from Australia, tax deductible at 30%, is beneficial to the group, as the non-Australian lender is often taxed at a lower rate on the corresponding interest income, if at all.

The thin cap rules are designed to limit the amount of otherwise tax deductible debt related expenses.

The ‘old’ thin cap rules (for inward investors)

The ‘safe harbour’ limit: The maximum debt limit is 3:1 on a debt-to-equity basis. Thus, the interest is only fully deductible if the total relevant debt is less than three times the equity. Interest on any ‘excess debt’ is not tax deductible. However, this only applies if the total debt deductions (interest etc.) exceed AUD 250,000 in the year concerned.

The ‘arm’s length’ test: Furthermore, there will be no limitation if the 3:1 ratio is exceeded, if the debt is shown to be an ‘arm’s length’ amount under the circumstances.

The new thin cap rules (for inward investors)

Date of change: the new thin cap rules apply to income years starting on or after 1 July 2014.
The ‘safe harbour’ limit: The maximum debt limit is reduced from 3:1 on a debt-to-equity basis to 1.5:1. Interest on ‘excess debt’ is not tax deductible. However, this only applies if the total debt deductions (interest etc.) exceed AUD 2,000,000 in the year concerned.
The ‘arm’s length’ test: There will still be no limitation, where the 1.5:1 ratio is exceeded if the debt is shown to be an ‘arm’s length’ amount under the circumstances.

Worldwide gearing debt amount: There will also be no limitation if it can be shown that the Australian company’s debt ratio is not higher than the group’s worldwide debt ratio, unless the worldwide equity is negative (there was previously no equivalent test for inbound investors into Australia).

Therefore, the maximum allowable debt under the thin cap rules will be the greatest of the following:

• The safe harbour debt amount
• The arm’s length debt amount
• The worldwide gearing debt amount

Contact

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