Thin Capitalisation changes
The Government recently passed changes to the Thin Capitalisation Rules to lower the Statutory 'Safe Harbour' debt thresholds to a 'more commercial' level. These changes have passed both houses of Parliament and are awaiting Royal Assent and are set to apply from 1 July 2014.
Australian taxpaying entities with foreign ownership or with investments outside Australia and foreign taxpayers operating in Australia may be subject to the 'Thin Capitalisation' rules. These rules aim to prevent revenue leakage by limiting the amount of 'debt deductions' (interest) that can be claimed where the entity is viewed as being 'thinly capitalised'.
Thin capitalisation refers to a company having excessive debt compared with equity to fund its assets.
If for example a foreign company could set up an Australian subsidiary with $100 share capital and loan $100 Million to the subsidiary and charge interest on that loan, any profits derived by that subsidiary would be reduced by interest deductions. Payments of interest to a non resident are subject to a 10% withholding tax while company profits are subject to a 30% income tax. Therefore, Thin Capitalisation rules were introduced to deny debt (interest) deductions above a certain debt capitalisation threshold to reduce the revenue leakage that may otherwise occur.
The tax law allows various ways of calculating a safe harbour level of debt where all deductions can be claimed. These include an 'arm's length debt test' (what could a stand alone entity without parent entity support be expected to borrow under certain 'standard' borrowing conditions) and a statutory safe harbour gearing ratio. The safe harbour threshold calculations have been tightened up to reflect a 'more commercial level of borrowing'.
Under the recent changes, the safe harbour gearing ratio has been reduced from the previous 3:1 (75% average debt to average assets value) to 1.5:1 (60% average debt to average asset value). This broadly means for every $1 Million of assets, if entities borrow more than $600,000 to fund the asset purchase, no tax deductions will be allowed for interest on borrowings above the $600,000 (60%).
Fortunately for SME's, a 'de minimus threshhold' exists such that the Thin Capitalisation rules do not apply to entities with annual total debt (interest) deductions of less than $2 Million (an increase from $250,000). This has been set to reduce compliance costs for SMEs.
Further, while thin capitalisation can affect individual taxpayers (foreign individuals investing in Australia), it is unlikely this will affect many due to the level of debt deductions at an individual level.
Affected entities will need to reconsider their debt structure to ensure that they can maximise debt deductions into the future.
Where entities are borrowing from overseas related entities, they also need to ensure that any dealings (including loans) are at arm's length. The entities need to ensure they have contemporaneous documentation showing how they have assessed that the interest rate and loan terms are on an arm's length basis. While no reporting of international transactions is required for related party dealings of less than $2 Million, the arm's length rules still apply.
Should you have any questions about how these changes may affect your business, please contact your usual Hanrick Curran advisor or speak with Jamie Towers on 07 3218 3900.