2013-2014 Australian Federal Budget - Government attacks thin capitalisation, offshore debt structures, tightens key tax concessions for multinationals and miners and expands compliance activities.
The Australian Government announced a range of important measures in the 2013-2014 Budget, which include significant modifications to the thin capitalisation regime, tightening cross border debt/equity structuring rules, critical changes to the foreign resident capital gains tax (CGT) regime, and reduced certain concessions for miners.
There are further initiatives to tighten several tax integrity rules and to expand ATO compliance activities.
We would expect most of these measures to progress into law, despite the upcoming election and the delayed start dates and further consultation announced on various measures.
We provide a more detailed analysis of the principal tax and related measures below.
1. THIN CAPITALISATION
The Australian thin capitalisation regime in Division 820 of the Income Tax Assessment Act 1997 (ITAA97) is aimed at limiting the amount of debt that multinational enterprises use to fund their Australian operations and to prevent excessive interest deductions.
The following key changes were announced in the Budget to the thin capitalisation rules:
- Reducing all safe harbour ratios and the worldwide gearing amount;
- Increasing the de minimis threshold from $250,000 to $2 million of debt deductions;
- Implementing a Board of Taxation review of the arm's length debt test
The proposed start date for these changes is 1 July 2014 and a summary of the existing rules and the proposed changes is provided below.
The thin capitalisation rules operate by denying deductions on a proportion of an entity's otherwise deductible interest, to the extent that the company's debt levels exceed certain thresholds (the 'maximum allowable debt'). Australian thin capitalisation rules apply to both inward and outward investing enterprises.
For inward investors (i.e. foreign residents or foreign controlled Australian entities), the maximum allowable debt is the greater of:
- Its 'safe harbour debt amount' or
- The 'arm's length debt amount'.
For outward investors (i.e. Australian entities that control foreign entities or operate a foreign permanent establishment), there is an additional 'worldwide gearing debt amount' and that can be used as the maximum allowable debt. This amount is currently 120% of the gearing levels of the investor's Australian and foreign investments.
Safe harbour debt amount and worldwide gearing
Under current rules, the safe harbour debt amount for most entities is equal to 75% of the average value of their Australian assets; i.e. a 3:1 debt to equity ratio (different ratios apply to banks and other financial entities).
Under the proposed changes, all safe harbour ratios will be reduced as follows:
- For general entities, the limit will be reduced from 75% to 60% of assets. This halves the effective debt to equity ratio to 1.5:1;
- For non-bank financial entities, the limit will be reduced from 20:1 to 15:1 on a debt to equity basis (or 95.24 per cent to 93.75 per cent on a debt to total asset basis); and
- For banks, the capital limit will be increased from 4 per cent to 6 per cent of their risk weighted assets of the Australian operations.
In addition, for outbound investors, the worldwide gearing ratio will be reduced from 120% to 100% of the gearing of their worldwide investments.
Clearly, these reductions will further limit the amount of debt that multinational enterprises can use to fund their Australian operations and the associated interest deductions they can claim in Australia.
Going forward, taxpayers will need to take into account the proposed reductions when structuring their financing operations in Australia and preparing any financial modelling of Australian investments.
Taxpayers with substantial intangible assets that may now exceed the safe harbour ratios under the proposed changes may wish to consider whether there is a reasonable and commercial basis for their intangibles to be revalued upwards. The thin capitalisation rules allow taxpayers to include the value of intangible assets (excluding internally generated goodwill) in the calculation of the safe harbour debt amount even if those assets are not currently recognised in their financial accounts.
De minimis test
Currently, the thin capitalisation rules do not apply in an income year where debt deductions (e.g. interest expenses) of the taxpayer do not exceed the de minimis threshold of $250,000. In the Budget, it was announced that the de minimis threshold will be increased to $2 million. Based on a 5% interest rate, the thin capitalisation rules would not apply until borrowings exceed $40m. This measure is aimed at reducing compliance costs for smaller businesses and will result in many smaller business operations no longer being subject to the thin capitulation rules in Australia.
Arm's length debt amount
The arm's length debt amount is a notional amount that represents the level of debt that an independent entity could be expected to borrow, and an independent commercial lending institution (e.g. a bank) would have lent, in the relevant circumstances and taking into account certain statutory factual assumptions.
The focus of the arm's length debt analysis is on the Australian operations of the taxpayer. The analysis looks to the assets of those operations as the source of cash flows to meet the debt repayments and the other liabilities of the operations. To sustain a high level of debt, the entity needs to consider what would have happened at arm's length under certain assumptions, and to demonstrate that continued sound operations under those assumptions could be reasonably expected.
The Government has announced it will implement a review of the arm's length test by the Board of Taxation, to consider ways to improve the operation and administration of this test. Prior to the Budget there was some speculation that the arm's length test would be eliminated but it has been retained at this time.
2. NON-PORTFOLIO DIVIDENDS
Two changes are proposed to the non-portfolio rules in section 23AJ of the Income Tax Assessment Act 1936 (ITAA36). One relates to the fact that this section considers the form of the interest (over the substance) and the other focuses on the "non-portfolio" concept.
Form vs substance
Currently the non-portfolio dividend exemption in section 23AJ takes a form over substance approach, whereby distributions from an offshore subsidiary, which are in legal form, dividends, enjoy exemption from Australian tax. This view was confirmed by the ATO in ATOID 2009/157.
As a result, certain structures using legal form shares, which are treated as debt under the debt equity rules (e.g. certain redeemable preference shares), effectively enable an exemption from Australian tax on "interest" payments.
The proposed change is to make section 23AJ subject to the classification rules in Division 974 of the ITAA97 such that returns on debt interests will not be treated as dividends under this section.
Certain structures using controlled foreign companies and section 404 of the ITAA36 allow distributions on interests, which are in substance portfolio holdings, to be treated as non-portfolio interests.
To negate this ability, the proposed change is to delete section 404 of the ITAA36.
Interestingly, the Government also announced that the tax exemption in relation to non-portfolio dividends will be extended to apply to non-portfolio dividends received via trusts and partnerships .
Section 25-90 ITAA97
Broadly, section 25-90 of the ITAA97 allows an Australian company to deduct interest on borrowings used to acquire or capitalise a non-resident subsidiary, where dividends received from that subsidiary are exempt under section 23AJ. It also applies to exempt income under Section 23AI and 23AK. As a result, companies do not currently need to distinguish between debt used for these purposes and debt used for other 'deductible' purposes (e.g. where debt deductions are obtained under section 8-1).
The effect of this section is another aspect of the cross border debt structure that the Assistant Treasurer mentions in his recent discussion paper.
Therefore, part of the proposed changes is to repeal the rule that allows a tax deduction for this interest expense. As a result, interest incurred on borrowings used to generate section 23AJ exempt income will not be deductible. Moreover, companies may now be required to calculate how much of their borrowings are used to generate section 23AJ exempt income and the commensurate interest expenses.
Date of effect
The proposed start date for the thin capitalisation changes, the non-portfolio dividend changes and the section 25-90 rule is 1 July 2014 to "provide time for taxpayers to rearrange their financing arrangements".
However, no transitional or grandfathering measures have been announced at this time, and a consultation process will be running beyond 12 July 2013 (being the closing date for submissions).
The Assistant Treasurer's discussion paper titled "Addressing profit shifting through the artificial loading of debt in Australia", focusses on a particular "debt dumping" financing structure which uses the thin capitalisation regime, the section 23AJ ITAA36 exemption for non-portfolio dividends and related interest deductions under section 25-90 ITAA97.
Despite the Assistant Treasurer's comments that these rules are targeting a specific "debt dumping" structure, these changes will affect many taxpayers and have a much wider application.
Therefore, affected multi-national groups should start considering how to recalibrate cross border funding structures to ensure they cater for these proposed changes.
3. TAXABLE AUSTRALIAN REAL PROPERTY ("TARP") RULES
Under Australian tax law, foreign residents are subject to CGT on the disposal of only a limited category of assets.
Among the most notable is indirect Australian real property interests, such as shares in companies and units in unit trusts (whether Australian or not) which hold significant:
- Australian real estate; or
- Mining, quarrying or prospecting rights if the minerals, petroleum or quarry materials are situated in Australia,
(each a Taxable Australian Real Property, or TARP, asset).
A foreign resident is liable for CGT on gains made from the disposal of an indirect Australian real property interest in an entity if, in addition to holding (together with any associates) at least 10% of the membership interests in that entity at certain times, that entity also passes the 'principal asset test'. The 'principal asset test' is passed if, at the disposal time, the sum of the market values of the entity's assets that are TARP exceeds the sum of the market values of its assets that are not TARP.
The Government announced that in determining the value of the TARP assets of the entity, intangible assets "connected to" the rights to mine, quarry or prospect for natural resources - notably goodwill, mining, quarrying or prospecting information, and rights to such information - will be treated as part of the mining / quarrying / prospecting rights to which they relate. Notably, this differs from the position currently adopted by the ATO whereby such information is not treated as a TARP asset because it is not considered to be a CGT asset (see ATO Interpretative Decision: 2012/13).
The Government states that this measure comes in response to recent cases where foreign investors disposed of an interest in an Australian mining company, but because the majority of the value of the company's mining operations was attributable to 'mining information' (which is not a TARP asset) as opposed to the right to extract those resources (which is a TARP asset), there was no CGT on the disposal of the interest, even on the gains attributable to the appreciation in the value of the mining right. This was the situation in the recent Federal Court decision in Resource Capital Fund III LP v Commissioner of Taxation  FCA 363.
Furthermore, measures will be introduced to remove the ability of foreign resident investors who control a consolidated or MEC group to use dealings between entities in the group (which are generally not subject to income tax under the tax consolidation rules) to generate non-TARP assets, diluting the proportionate value of the TARP assets of the group.
10% TARP Withholding Tax
In addition, a 10% non-final withholding tax is set to apply from 1 July 2016 to the disposal by foreign residents of certain taxable Australian property (excluding residential property valued under $2.5 million).
The Government is to release a detailed discussion paper on these measures later in 2013.
This is the second round of measures announced in recent months aimed at tightening CGT concessions for foreign residents, see DLA Piper Tax Update regarding removal of the CGT discount for foreign resident individuals: Australian Tax Laws Amendment (2013 Measures No. 2) Bill 2013: Removing CGT discount for foreign individuals
4. SCALING BACK OF MINING EXPLORATION AND PROSPECTING EXPENDITURE CONCESSIONS
Under current rules, concessional tax deductions are available for certain mining capital expenditure. In particular, expenditure incurred on exploration or prospecting for minerals is generally deductible upfront, in the year incurred under Subdivision 40-H of the ITAA97. The deduction is available for both capital and revenue expenditure, but does not apply to the cost of depreciating assets.
"Exploration or prospecting" can include mapping, surveys, searches for areas containing minerals, exploration drilling and appraisal drilling. Feasibility studies to evaluate the economic feasibility of mining minerals, petroleum or quarry materials also qualify as exploration or prospecting.
In the Budget, it was announced that the immediate deduction will no longer be available for the acquisition of mining rights and mining information. Instead, these costs will be depreciated over 15 years, or their effective lives, being the life of the mine they lead to, whichever is shorter. Subsequently, if it is established that the exploration is unsuccessful, any remaining undeducted expenditure can be written off immediately at that time.
Not all deductions for mining rights and information expenditure will be denied as an immediate deduction. In particular, the immediate deduction will still be available for:
- Expenditure by a taxpayer of generating new information or improving existing information (as opposed to acquiring existing information);
- Expenditure on acquiring mining rights andinformation from a relevant government authority;
- Farmees that acquire mining rights under a recognised 'farm-in, farm-out' arrangement will also still be eligible for the deduction.
In addition, other mining capital expenditure that currently qualifies for the immediate deduction and is not expenditure on mining rights or information should still qualify for the immediate deduction.
The Government has also proposed to address the possibility of concessional tax treatment regarding the exchange of mining rights, where integrity is not at risk.
The measure applies to taxpayers who start to hold the mining right or information after 7.30pm (AEST) on 14 May 2013 (i.e. the time of the Budget announcement) unless the taxpayer has already committed to the acquisition of the right or information or are taken by law to already hold the right or information before that time.
Although the scaling back of the immediate deduction is not as widespread as expected, taxpayers with mining operations will still need to take into account the loss of the immediate deduction for expenditure on acquiring mining rights and information in forecasting their financial returns from a mining project. In particular, the loss of the immediate deduction may result in income tax being payable (and needing to be funded) at an earlier than anticipated time in the life of the project.
5. OFFSHORE BANKING UNIT (OBU) REGIME
Reflecting growing concerns about banks shifting profits from domestic banking operations to their OBUs, and to properly target the concession to genuinely mobile banking businesses, the Government has announced three principal refinements to the OBU regime as follows:
- Treat dealings with related parties as ineligible for OBU treatment;
- Treat transactions between OBUs as ineligible for the OBU concession; and
- Tighten the list of eligible OBU activities.
Further consultation with business will be undertaken (including regarding the allocation of expenses between OBU and non-OBU Activities) on the changes and these will be operative for the income years commencing on and after 1 July 2013.
6. OTHER INTEGRITY RULES
The Australian Treasurer also announced several important integrity measures, effectively closing perceived unfair business tax loopholes. These measures include:
- A tightening of the rules for consolidated and MEC groups which will prevent the shifting of values between related entities and potential double deductions;
- Specifically preventing 'dividend washing' and the ability to trade in franking credits and receive two sets of franking credits for the same parcel of shares;
- Increased ATO compliance activities on business restructures, offshore marketing hubs, trust restructures and concealment of income, increased third party reporting and data matching.
We trust you have found this briefing useful. If you have any questions or queries about any of the material, please contact any member of our Tax team. Contact details are provided on the following page.
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