The Government has proceeded with the amendments to the thin capitalisation, foreign non-portfolio dividends and foreign residents capital gains rules with the Tax and Superannuation Laws Amendment (2014 Measures No 4) Bill 2014 passing the Senate on 25 September 2014.These measures were initially proposed in the 2013-14 Budget and are part of the Government's wider strategy around base erosion and profit shifting, more commonly referred to as BEPS. Importantly, the amendments include an integrity measure limiting the operation of the non-portfolio dividend exemption in section 23AJ, also proposed in the 2013-14 Budget. This will mean that multinational organisations' will be no longer be able to reduce their Australian tax through debt loading which previously exploited the debt / equity mismatch in the exemption.
Thin Capitalisation Reforms
Thin Capitalisation rules were first introduced in 1987 (and subsequently amended in 2001) to limit the amount of debt deductions that could be claimed for certain inbound and outbound investors. These provisions operate by denying deductions for interest expenses and borrowing costs when certain gearing thresholds are exceeded. The rules have the intended effect of limiting a multinational organisations' ability to shifting profit overseas by allocating an excessive amount of debt in their Australian operations, thereby reducing their Australian taxable income. Such entities which are highly geared are said to be 'thinly capitalised'.
Broadly, there are three ways to calculate the maximum amount of debt allowed:
- the safe harbour debt amount;
- the arms-length debt amount; and
- the 'worldwide gearing debt amount'.
These rules have been amended to limit profit shifting and to reduce compliance costs and fall in line with the exposure drafts released earlier in the year. The key changes include:
- Reduction of the safe harbour debt limit from a debt-to-equity ratio of
- 3:1 to 1.5:1 for general entities; and
- 20:1 to 15:1 for non-bank financial entities
- Allowing the worldwide gearing ratio to be available to inbound investors and reducing the ratio from 120% to 100%;
- Increasing the safe harbour capital limit for Authorised Deposit Institutions (ADIs) from 4% to 6% of their risk weighted Australian assets; and
- Increase the De Minimis threshold from $250,000 to $2 million of debt deductions.
Although the Bill has just been passed, these changes apply retrospectively from 1 July 2014. Therefore, it is essential for businesses to consider the implications of these changes on their financing arrangement now.
Due to the substantial increase to the De Minimis threshold, entities with debt deductions less than $2 million will be positively impacted by these changes, and will effectively be able to disregard the thin capitalisations provisions altogether. Conversely, those entities to which the Thin Capitalisation rules do apply will be potentially worse off as the prescribed safe harbour gearing ratios have been squeezed. Given this it is now worthwhile considering strategies that could improve an entity's ability to fall within the reduced safe harbour's and limit the potential for non-deductible finance costs. These methods may include:
- Revaluation or review of assets especially intangible assets.
- Increasing asset levels through capital injection or other forms of restructure.
- Repayment of debt to reduce liability levels.
These methods should be considered in order to understand the full tax implications to the company as whole. Importantly where an entity takes steps to revalue assets for the purpose of the thin capitalisation provisions it is crucial that the appropriate support for the revaluation is maintained.
Foreign Non-Portfolio Dividends
Section 23AJ of the Income Tax Assessment Act 1936 allows a non-portfolio dividend to be non-assessable non-exempt income and therefore not subject to tax. The new law, rewritten into Division 768 of the Income Tax Assessment Act 1997 (ITAA 1997), will broaden the tax exemption to be available where an Australian company (or corporate tax entity) receives a foreign non-portfolio distribution of an equity interest (e.g. a dividend) through an interposed trust or partnership.
Currently, the operation of section 23AJ is limited to direct shareholdings by Australian resident companies and does not take into account the debt / equity classification of the 'dividend' received. This means that if a dividend is paid by a foreign company to an Australian company indirectly via a fixed trust or partnership the exemption will not be available. Furthermore, the current application of section 23AJ provides tax relief for companies that received dividends paid in respect of a debt interest (e.g. certain redeemable preference shares), which can lead to arguably inappropriate tax arbitrage opportunities.
Specifically, the new Division 768 requires an Australian corporate tax entity to have a 10% 'participation interest' rather than a 10% 'voting interest' in the foreign entity which pays the distribution. The participation interest includes both direct and indirect participation interests. The result of this change is that a foreign dividend paid to an Australian corporate tax entity through a trust or partnership entity will now be classified as non-assessable non-exempt income in the hands of the Australian corporate tax entity and as a result will not be subject to income tax.
Furthermore, the new rules extend the exemption to public trading trusts, corporate unit trusts and corporate limited partnerships that are in most other respects taxed like a company. Although the new rules have a broader application, the revised rules ensure that the distribution made to the Australian company must be classified as 'equity' in accordance with Division 974 of the ITAA97. This will limit a multinational organisation's ability to reduced Australian tax by debt loading its Australian operations.
Foreign Residents Capital Gains Tax Regime
Broadly speaking foreign residents will be effectively exempt from Capital Gains Tax (CGT) if the asset is neither a direct or indirect interest in Australian real property. Whether a share in a company or an interest in a trust is an indirect interest in Australian real property depends on whether the company or trust (in which the share or interest is held) passes the Principle Asset Test.
The main changes to these provisions involve amendments to the Principal Asset Test, which can be manipulated by way of double counting of certain assets and liabilities of related parties. The new measures requires that where the assets of two or more entities are included in the Principal Asset Test, the market value of new non-TARP assets arising from certain arrangements (e.g. intercompany loans) involving those entities will be disregarded. This essentially ensures that no assets are duplicated in the Principal Asset Test.
With the previous amendments to the transfer pricing provisions and now the refinement of the thin capitalisation rules and associated measures the Government has demonstrated its commitment to the agenda for international tax reform as part of the wider BEPS strategy. Given the increasing complexity of Australia's international tax laws it is becoming increasing difficult for a business with cross border operations to successful navigate the journey alone. As such Moore Stephens international tax experts are well placed to assist your business understand these changes.
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