Pointon Partners LAWYERS CHANGES TO THIN CAPITALISATION RULES INTRODUCTION Since 1987 Division 16F of the Income Tax Assessment Act 1936 thin capitalisation rules have sought to ensure that foreign investors having an interest of at least 15% in an Australian business maintained an appropriate balance between the debt the business owes to them and their equity in that business. The object of ''thin capitalisation'' measures is to prevent the use of excessive ''in- house'' loans which would be detrimental to the Australian revenue by reason of the fact that profits would effectively be shifted to the foreign controller of the business in the form of tax deductible interest payments which would only be subject to Australian tax to the extent of the 10% withholding tax on interest. The broad scheme of Div 16F is to disallow deductions for interest to the extent to which they relate to foreign debt that exceeds the relevant ''foreign equity product''. The Division may apply to interest payable by a resident company, a trust estate or a partnership to a ''foreign controller'' or a non-resident associate of the foreign controller and also may apply to interest payable by a ''foreign investor'' to a non- resident associate. As part of The New Tax System, the Government has enacted legislation to replace the former thin capitalisation rules (Division 16F of Part III Income Tax Assessment Act 1936). For affected entities, the new thin capitalisation rules (Division 820 of Income Tax Assessment Act 1997) apply from the entity’s first income year beginning on or after 1 July 2001. FORMER THIN CAPITALISATION RULES The key terms of Div 16F are: ! foreign debt interest; ! foreign debt; ! foreign equity product; and ! foreign equity. In the case of a resident company, a partnership or a trust, the other key term is ''foreign controller''. Foreign debt interest is interest payable on ''foreign debt'' (sec 159GZA ITAA 1936) Foreign debt is, in the case of a resident company, a partnership or a trust estate, the balance of any amount owing on which interest is payable to a ''foreign controller'' debt'' (sec 159GZF ITAA 1936). Pointon Partners LAWYERS Foreign controller in relation to a resident company is a non-resident who or which, either alone or together with an associate or associates (who may be residents or non- residents), has ''substantial control of the voting power'' in the company, is beneficially entitled to receive, directly or indirectly, at least 15% of any dividends or capital distributions that are or might be paid or made by the company or is capable, under a scheme, of gaining such control or such an entitlement debt'' (sec 159GZE ITAA 1936) Foreign equity product is generally the amount ascertained by multiplying the foreign equity of the company, partnership or trust by two (by three, for pre-1997/98 years of income). However, in the case of a resident company that is a financial institution, the multiplication factor is six (sec 159GZA ITAA 1936). The so called “thin capitalisation” rules restrict the deductibility of interest paid by an Australian enterprise on debts owing by it to a non-resident who is a “foreign controller” who holds at least a 15% interest in the enterprise (ITAA36 section 159GZA to 159GZX) The effect of the statutory restrictions is that deductions for interest on debt owing to the foreign controller are allowable only to the extent that the debt does not exceed the permitted foreign equity product. The permissible ratio of debt to equity is generally 2:1 (ie for every two dollars the foreign controller lends to the Australian business, that person is required to have at least one dollar of equity). Application of debt/equity ratio For the purpose of calculating the debt/equity ratio, “foreign equity” will generally include the direct interest of the foreign controller (or a non-resident associate) in the share capital, reserves and unappropriated profits. Foreign equity is reduced by amounts lent back by the company to the foreign controller. Foreign debt is measured as the greatest total of foreign debt at any time throughout the relevant income year, unless a taxpayer elects the alternative method which enables debt to be measured on a weighted average for those days on which the debt/equity ratio is exceeded. The amount of foreign debt interest disallowed (section 159GZS ITAA 1936) under the thin capitalisation rules is calculated as follows: Foreign debt interest x Greatest total foreign debt – (Foreign equity product) otherwise allowable Greatest total foreign debt In the case of a wholly-owned resident company group, the debt/equity ratio is normally applied on a group basis, rather than separately to each company in the group. The total foreign debt of all the companies in the group is taken into account, Pointon Partners LAWYERS but the foreign equity for this purpose only includes the foreign equity of the holding company. NEW THIN CAPITALISATION RULES The new thin capitalisation legislation can apply to both foreign controlled Australian investments and to Australian entities investing overseas. The new rules seek to limit the amount of debt used to fund those Australian operations or investments. They do so by disallowing the debt deductions that an entity can claim against Australian assessable income when the entity’s debt to equity ratio exceeds certain limits. A debt deduction is an otherwise deductible expense incurred in connection with a debt interest, such as an interest payment or a loan fee. Certain expenses are excluded from being debt deductions under the legislation, including rental expenses on certain leases and some foreign currency losses. Examples of debt interests are a loan, a bill of exchange, or a promissory note. Generally, interest free debt will not count as part of an entity’s debt. The new rules do not apply to an entity whose debt deductions, together with those of its associated entities, are $250,000 or less for an income year. They also do not apply where the foreign assets of an entity and its associates represent 10 percent or less of their combined Australian and foreign assets. Why have the new rules been enacted? The previous thin capitalisation rules were not fully effective at preventing an excessive allocation of debt to the Australian operations of multinationals because they only: ! related to foreign related-party debt owed by an Australian entity; and ! applied to inward-bound investment, meaning Australian entities or operations controlled by non-resident entities. However, the new rules apply to ! the total debt of an entity’s Australian operations, rather than just foreign related- party debt; and ! out-bound investment as well as in-bound investment. Outward investing entities are Australian entities that invest in Australian controlled foreign entities or have foreign permanent establishments Which entities are affected by the new rules? The new thin capitalisation rules affect entities with operations or investments both in Australia and overseas, and apply to both inward investing entities and outward investing entities, as well as to associated entities of outward investing entities. Affected entities are companies, trusts, partnerships and individuals. Pointon Partners LAWYERS An outward investing entity is an Australian entity that: ! is an Australian controller of a controlled foreign entity; ! carries on business through an overseas permanent establishment (such as a branch); or ! is an associate entity of either of the above (more detail on this below). An example of an outward investor is an Australian company that has 51 per cent shareholding in a Singaporean company. An inward investing entity is either ! an Australian entity controlled by a foreign entity; or ! a foreign entity that derives Australian assessable income through an Australian permanent establishment or direct Australian investment. An example of an inward investing entity is an Australian company that is a subsidiary of a United Kingdom company. Associate entities The new rules also affect associate entities. An associate entity is an entity (eg entity ‘A’) that is an associated of another entity (eg entity ‘B’) under sections 318 of ITAA 1936, and then either: ! entity B holds an interest of 50 per cent or more in entity A; or ! entity A (either directly or indirectly) is under an obligation or reasonably expected to act in accordance with the directions, instructions or wishes of entity B in relation to whether entity A retains or distributes its profits or its financial policies. Which entities are not affected by the new rules? For a given income year, the following entities are not affected by the new rules: ! an entity that does not incur debt deductions for the income year; ! an entity whose debt deductions (together with those of any associate entities) are $250,000 or less for the income year; ! an Australian resident entity that is not an inward investing entity nor an outward investing entity; ! a foreign entity that has no investment or presence in Australia; and ! an outward investing entity that is not foreign controlled and that has small overseas investments. This means that the foreign assets of the entity and any associates represent 10 per cent or less of their combined Australian and foreign assets. Pointon Partners LAWYERS How do the new rules work? The thin capitalisation rules apply differently to an entity depending on whether the entity is: ! an inward investing entity or an outward investing entity; ! a general entity or a financial entity (eg. finance companies or securities dealers); or ! an authorised deposit-taking institution (ADI) (eg. Australian banks and foreign banks with branches in Australia). These categories determine how to calculate the maximum allowable debt. Under the first category, the new rules require an inward investing entity/ outward investing entity to calculate its adjusted average debt and then compare it to the maximum allowable debt as prescribed under the rules. Debt deductions will be disallowed to the extent that the amount of adjusted average debt used to fund an entity’s Australian operations exceeds the prescribed maximum allowable debt. For the outward investing entity, the maximum allowable debt (section 820-90 ITAA 1997) is the greatest of the following amounts: ! The safe harbour debt amount (which is three-quarters of the average value of the entity’s Australian assets, for entities that are not financial entities. This as also known as the safe harbour ratio of 3:1) (section 820-95 ITAA 1997); ! the arm’s length debt amount (which is the amount of debt that would have been borne by an independent party carrying on the entity’s Australian operations); or ! the worldwide gearing debt amount (which can allow the Australian operations, in certain circumstances, to be geared at up to 120 per cent of the gearing of the Australian entity’s worldwide group) (section 820-110 ITAA 1997). For the inward investing entity, the maximum allowable debt (section 820-90 ITAA 1997) is the greater of the following amounts: ! the safe harbour debt amount; or ! the arm’s length debt amount Under section 820-630 ITAA 1997 entities must calculate the average values of their assets, liabilities and debt in order to undertake their thin capitalisation calculations. The rules provide 3 methods for determining average values, which are: ! the opening and closing balances method (an average of the opening and closing values for the period); ! the 3 measurement days method (an average based on 3 specified days during the period); or. ! the frequent measurement method (an average using quarterly/ monthly/ weekly/ daily measurement days). Pointon Partners LAWYERS For the first year of application, a taxpayer may choose to use end-of-year values only, rather than having to calculate an average figure as outlined above. Grouping Australian resident entities can choose to form a group to apply the thin capitalisation rules rather than have them applied to the individual entities within the group. The thin capitalisation group can include wholly-owned resident companies, trusts and partnerships. CONCLUSION ON THIN CAPITALISATION CHANGES The thin capitalisation measures are aimed at preventing foreign companies from acquiring or investing in a local company through significant debt borrowing when compared to the actual amount of equity invested. The measures are aimed at limiting the amount of interest a company may claim as a deduction. Any amount in excess of the permitted ''foreign equity product'' would be denied as a tax deduction. Under the former thin capitalisation rules foreign equity product is generally the amount ascertained by multiplying the foreign equity of the company by two (section 159GZA ITAA 1936). Foreign and domestic debt now included Under the new thin capitalisation rules the debt/equity ratio or “safe harbour” ratio for inward investing and outward investing entities have been increased from 2:1 to 3:1. This would appear to favour foreign companies operating in Australia and Australian controlled companies operating overseas. Indeed, many of the OECD and G7 economies have debt/equity ratios of 1.5:1 and 2:1. However the amendments do not take into account just the foreign debt. From 1 July 2001 in calculating whether the debt/equity ratio has been violated a company must include both foreign and domestic debt. Therefore companies which previously complied with the 2:1 ratio could be caught by the amendments due to the inclusion of the domestic debt. Arm’s length test Although the changes are likely to impact upon a significant number of companies where the gearing exceeds the “safe harbour” ratio, multinationals will not be affected by the rules if they satisfy the arm’s length test. In essence this test is satisfied if the debt to equity ratio of an entity is no greater than it could achieve on an arm’s length basis as an independent entity. Pointon Partners LAWYERS Nevertheless, entities caught by the thin capitalisation amendments will need to consider their existing debt/equity ratios and the likely impact domestic borrowing may have upon the new 3:1 ratio. Therefore companies may need to restructure existing debt in order to comply with the new rules. If you have any queries please contact Tony Pointon or Joseph Santhosh.