On 16 October 2014, changes to Australia's thin capitalisation and non-portfolio dividend exemption rules received Royal Assent.
The changes to the thin capitalisation rules represent a significant tightening of the rules for many taxpayers, with a material impact on the availability of interest deductions. Concessional changes to the rules will also impact those taxpayers.
The changes to the non-portfolio dividend exemption for foreign dividends are driven by integrity concerns around the debt/equity divide.
When Will the Changes Come Into Effect?
The changes to the thin capitalisation rules will apply to income years commencing on or after 1 July 2014, while changes to the non-portfolio dividend exemption rules will apply to distributions and non-share dividends made on or after 17 October 2014 (the day following Royal Assent).
Thin Capitalisation Rules
Broadly, the thin capitalisation rules operate to disallow a proportion of otherwise deductible debt related expenses where the debt allocated to a multinational's Australian operations exceeds certain statutory limits. These limits are determined by reference to the greater of a 'safe harbour' debt amount, an 'arm's length' debt amount and, previously only for certain outbound investors, the 'worldwide gearing' debt amount. For Authorised Deposit-taking Institutions (ADIs), the tests are based on a minimum requirement for equity capital based on prudential regulatory requirements.
Tightening of Rules
The amendments have tightened the maximum statutory debt limit and worldwide gearing ratios for taxpayers subject to the rules. The stated purpose of these changes is to ensure that multinationals do not allocate a disproportionate amount of debt to their Australian operations and therefore prevent erosion of the Australian tax base.
Specifically, the following changes have been made.
- The safe harbour debt limit for general entities (non-ADI) has been reduced from 3:1 to 1.5:1 on a debt-to-equity basis.
- The safe harbour debt limit for financial entities (non-ADI) has been reduced from 20:1 to 15:1 on a debt-to-equity basis.
- The safe harbour capital limit for an ADI has been increased from four per cent to six per cent of its risk weighted Australian assets.
- The worldwide debt limit for outward investing entities (non-ADI) which previously allowed the Australian operations, in certain circumstances, to be geared at up to 120% of the gearing of the entity's worldwide group has been reduced to 100% of the gearing of the entity's worldwide group.
- The worldwide capital amount for ADIs which previously allowed the entity's Australian operations to be capitalised at 80% of the capital ratio of the Australian entity's worldwide group has been increased to 100%.
The amending legislation also introduces welcome concessional changes for small businesses. The 'de minimis' threshold for thin capitalisation limits has been increased from AUD250,000 to AUD2 million of debt deductions. This means that businesses with debt deductions of less than the new threshold, will not have any debt deductions denied which will ease compliance costs for small businesses.
Changes to Tests for Inward Investing
Another concessional change was introduced for 'inward investing entities' (non-ADI). Broadly, an inward investing entity is a foreign controlled Australian resident, and any foreign entity doing business in Australia through a permanent establishment or otherwise directly investing into Australia.
A new 'inbound' worldwide gearing debt test has been introduced, which will provide greater flexibility for these entities. Under the new law, the maximum allowable debt for an inward investing entity (non-ADI) in an income year will be the greatest of the following amounts:
- the safe harbour debt amount;
- the arm's length debt amount; or
- the worldwide gearing debt amount unless:
- the entity's statement worldwide equity, or statement worldwide assets is nil or negative;
- audited consolidated financial statements do not exist; or
- an assets threshold is satisfied.
Allowing a worldwide gearing debt test to be available to inward investing entities better reflects the policy intent of the thin capitalisation rules to prevent the disproportionate allocation of debt to Australia for income tax purposes. This is achieved by allowing the Australian operations to claim deductions on their debt where they are geared to the same level as the global group.
This will provide a further option to inward investing entities where they do not fall within the safe harbour limit and do not meet the arm's length debt test. To minimise compliance costs, this test will utilise the audited consolidated financial statements that are already required to be prepared by the worldwide parent entity.
Non-Portfolio Dividend Exemption Rules
Prior to the introduction of the amendments, a dividend paid to a company where the company had a voting interest amounting to at least 10% of the voting power in a foreign company paying the dividend was 'non-assessable non-exempt' income. The debt/equity rules in the tax legislation previously did not apply to this exemption.
The amendments mean that going forward this exemption will only apply to returns on instruments that are classified as an 'equity interest' under the debt-equity rules. This is will exclude any returns paid on 'debt interests' from this exemption. However, the exemption has been expanded so that it will apply where a distribution flows through interposed trusts and partnerships, which it previously did not allow, and also to a broader range of equity-like interests, rather than interests that involve significant voting rights.
The proposed changes will require affected taxpayers to review existing funding arrangements to determine the characterisation of the relevant interest under the debt/equity rules for Australian tax purposes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.