In its 2013-2014 Budget, the Federal Government announced that the thin capitalisation rules will be modified.
What is thin capitalisation and which companies does it apply to?
Thin capitalisation is a tax rule commonly found in OECD economies which limits the amount of tax deduction that can be claimed by an inbound (investing into Australia from overseas) or outbound (investing into overseas from Australia) entity. The broad purpose of the rule is to prevent the use of debt deductions as a method of shifting profits from Australia to a jurisdiction with lower tax rates (e.g. Hong Kong and Singapore).
How does it currently work?
Thin capitalisation only applies to entities whose interest deduction in Australia exceeds AUD$250,000 per annum. There are a number of methods to work out what is the maximum deduction, including:
1. "Safe harbour" test
2. "Arms length debt test"
3. "Worldwise gearing ratio" test
The majority of entities choose the Safe harbour test because this is the simplest test to apply. Broadly, under this test a company starts to lose its interest deductions if its debt is more than 3 times of its equity.
What are the new rules?
The new rules apply from 1 July 2014 for entities with a year end of 30 June. For most subsidiaries of Chinese parent companies, they will have a 31 December year end. For them the new rules will apply from 1 January 2015.
For most taxpayers, the safe harbour test will be tightened so that a company starts to lose its interest deductions if its debt is more than 1.5 times of its equity. This is less attractive than the current ratio of 3, and for affected companies this means more tax to pay.
However, there is good news for small to medium companies. The current $250,000 minimum threshold will be increased to $2m. This means that thin capitalisation will not apply to any company with interest deductions of less than $2m.
What should I do now?
Speak to the Azure tax team to determine whether the interest deduction for your company exceeds $2m. Note that this may not be straight forward because certain companies may need to be grouped together.
If the interest is expected to exceed $2m, consider the following possible remedies immediately:
1. Consider what you can do to reduce the debt levels - for example convert a related party debt into equity. Speak to the Azure tax team regarding this because such a measure can result in other tax issues including taxable foreign exchange gains/losses and "debt forgiveness" rules.
2. Consider if you will adopt the Arms length debt test or Worldwise gearing ratio instead of the safe harbour test. Note that the Federal Budget also includes upcoming changes to these two tests.
This article is intended to provide general information only, and is not to be regarded as legal or financial advice. The content is based on current facts, circumstances, and assumptions, and its accuracy may be affected by changes in laws, regulations, or market conditions. Accordingly, neither Azure Group Pty Ltd nor any member or employee of Azure Group or associated entities, undertakes responsibility arising in any way whatsoever to any persons in respect of this alert or any error or omissions herein, arising through negligence or otherwise howsoever caused. Readers are advised to consult with qualified professionals for advice specific to their situation before taking any action.
Comment