Amendments to the thin capitalisation rules
As foreshadowed, the Government has announced that it will reduce the amount of potential deductions available to foreign controlled and/or outbound entities funded by debt.
At present, the ability of businesses to deduct debt deductions (broadly interest and other borrowing costs) is limited by the thin capitalisation rules. Those rules provide for a statutory safe harbour entitling entities to claim deductions for interest (and other debt related expenses) subject to the level of gearing not exceeding, in broad terms, 75% (in the case of general entities) of the accounting value of the entity’s assets (less non-debt liabilities). The rules also provide for an alternative “arm’s length” debt test and “worldwide gearing” test (currently available to outbound investors only).
The proposed measures include:
- for general entities, reducing the statutory safe harbour from 75% to 60% of assets (ie effectively reducing the permissible debt to equity ratio from 3:1 to 1.5:1);
- for financial (non-Authorised Deposit taking Institutions (ADIs)), reducing the safe harbour from 95.24% to 93.75% of assets (ie effectively reducing the permissible debt to equity ratio from 20:1 to 15:1);
- for ADIs, the capital limit will be increased from 4% to 6% of their risk weighted assets of the Australian operations;
- increasing the de minimus threshold for debt deductions to $2,000,000 per annum (from $250,000);
- extending the worldwide gearing test to inbound investors.
The Government has also announced that it will ask the Board of Taxation to undertake a review of the effectiveness of the arm’s length debt test to make it easier to administer, to reduce compliance costs, as well as the overall targeting of the arm's length debt test. The terms of reference for the review are expected to be released in coming weeks.
The measures are proposed to take effect from the income year commencing on or after 1 July 2014.
The changes to the thin capitalisation ratios for “general entities” were widely anticipated prior to the Budget. While the deferral of the changes to 1 July 2014 is welcome, the new regime will result in material changes to the way in which Australian investments are funded. Clearly, the major issues relate to legacy structures and additional sources of equity funding will need to be drawn on in many instances in order to prevent a loss of tax deductions.
Removal of the statutory deduction for debt deductions incurred in acquiring certain foreign shareholdings
The Government has announced it will act to remove what it considers to be a loophole in section 25-90 of the Income Tax Assessment Act 1997. Section 25-90 enables Australian taxpayers to claim deductions for interest and other debt deductions where the dividends which they will receive on their shareholding are exempt from Australian income tax (eg foreign non-portfolio shareholdings).
In announcing the measure, the Government has stated that the measure is currently being abused as part of profit-shifting structures by artificially loading debt into Australia with no significant change to economic activity in Australia.
We believe that these measures (together with the proposed changes to the thin capitalisation rules) will have a significant impact on the use of Australia as a location for regional holding companies. The measures will likely result in a significant unwinding of most Australian centred debt funded holding structures because of the denial of interest and other debt deductions post 30 June 2014.
In making these amendments, there is a presumption that the deduction available under the current law is being abused as part of profit shifting structures with no significant change to economic activity in Australia. However, this overlooks the fact that many deductions being claimed under section 25-90 relate to structures which have been put in place as a result of genuine mergers and acquisitions. For example, if an Australian tax consolidated group acquires the shares in another Australian group using debt, and the target group has foreign subsidiaries sitting under an Australian holding company, a proportion of the deductions otherwise available on the acquisition debt interest would be denied tax deductibility. This would arise because, under the tax consolidation “single entity rule”, the head company of the acquirer group would be taken to hold the shares in the foreign subsidiaries of the target.
The measures are proposed to take affect from income years commencing on or after 1 July 2014.
Board of Taxation review into debt/equity rules
The Government has announced a post-implementation review by the Board of Taxation into the debt/equity rules contained in Division 974 of the Income Tax Assessment Act 1997 to “address any inconsistencies between Australia and other jurisdictions debt and equity rules that could give rise to tax arbitrage opportunities”.
The Government is expected to announce the terms of reference for the review in the coming weeks.
Strengthening of Controlled Foreign Company (CFC) rules in line with OECD recommendations
The Government has announced that it will reconsider the previously reform to the CFC and foreign source income attribution rules once a review by the OECD is completed. For many clients, this represents an unacceptable “limbo” with no real ability to forecast future exposures under the CFC rules while this important reform remains outstanding.
Amendments to the Foreign Resident CGT regime
In one of the most significant reforms to the rules regarding the taxation of capital gains made by foreign residents (since the rules were significantly amended in 2006) the Government has proposed amendments, some of which will apply to CGT events occurring after 7:30pm, 14 May 2013 (AEST) and others which are proposed to apply from 1 July 2016.
Clarification of Australian Taxing Rights over Indirect Australian Real Property Interests
With effect for CGT events occurring after the announcement:
- in determining the value of the Taxable Australian Real Property assets (TARP) of the entity in which the interest is held, intangible assets connected to the rights to mine, quarry or prospect for natural resources (notably mining, quarrying or prospecting information, rights to such information and goodwill) will be treated as part of the rights to which they are related – this amendment appears to be clearly targeted at the recent decision in Resource Capital Fund III LP vs Commissioner of Taxation  FCA 363 (RCF). The practical effect of this change is that investors who hold shares in mining companies who, in light of the RCF decision may not have otherwise held shares which constitute Taxable Australian Property (TAP), will now be taken to hold TAP assets, and be subject to Australian CGT on a disposal of their shares; and
- intercompany dealings between entities in the same tax consolidated group will not form part of the principal asset test calculations, thereby ensuring that assets cannot, in effect, be counted multiple times, thereby diluting the true asset value of the group. This measure is directed at planning which has been undertaken in the past by some taxpayers with the effect that the value of “good assets” (i.e. non-TARP assets) exceeds that of TARP assets. Accordingly, non-residents contemplating a disposal of shares in a company, which has previously carried out such structuring, will need to revisit their Australian tax position.
Withholding from Foreign Residents disposing of assets that give rise to an Australian Tax liability
With effect from 1 July 2016, it is proposed that a non-final withholding regime will be introduced to support the operation of the foreign resident CGT regime. In broad terms if a non-resident disposes of certain TAP, the purchaser will be obliged to withhold and remit to the ATO 10% of the proceeds from the sale. Residential property transactions valued under $2.5 million will be excluded from this measure. It should be noted that not only will this withholding apply to the taxation of capital gains, it will also apply where the disposal of the relevant TAP asset is likely to generate gains on revenue account, and therefore be taxable as ordinary income rather than as a capital gain. Following the announcement of this measure, the Government proposes to consult on the design and implementation of the regime to minimise compliance costs including permitting pre-payment of tax liabilities by the seller, removing a withholding obligation where it can be shown that no gain will arise and streamlining any payments required including through the use of intermediaries.
Key implications of CGT reforms
There are a number of key implications for non-resident investors arising from these measures, including:
- Investment decisions may have been made in the past based on the expectation that a disposal of their shares would not be taxable in Australia. With the proposed changes which render mining, quarrying or prospecting information, rights to such information, goodwill and other intangible assets as if they are part of the mining right and hence TARP, foreign resident taxpayers will now need to factor in potential CGT liability on an exit of their investment. Clearly this may not have been contemplated at the time of making the investment.
- The proposed introduction of a withholding regime raises many practical issues. For example, sellers will need to proactively engage with buyers (and potentially the ATO), prior to a sale proceeding, to have an established and certain position on whether:
- the asset being disposed of constitutes TAP; and
- whether a gain even arises.
Absent action from the seller, the possibility exists of a withholding impost which exceeds the amount of gain realised by the seller on disposal of the relevant asset. A simple example illustrates the principle: assume that a non-resident acquires shares in company A for $100 and sells those shares two years later for $90. Even though the non-resident has made a $10 capital loss, under the proposed rules a $9 withholding obligation exists for the purchaser of those shares. The seller would need to then lodge a tax return to claim the tax back.
- There may well be practical difficulties associated with complying with this regime in circumstances where a purchaser is outside the Australian tax system, for instance in circumstances where one non-resident sells to another.
Amendments to the income tax consolidation rules
The Government has announced a suite of measures applying to transactions that take place after 14 May 2013 aimed at closing tax loopholes that exist in the income tax consolidation rules. The measures address a number of issues raised by the Board of Taxation in reports issued in June 2012 and April 2013 (indeed, some of the measures respond to issues raised in two Board of Taxation reports released on Budget Day). These measures are expected to have a gain to revenue of an estimated $540 million, and to protect a significant amount of revenue over the forward estimates period.
Some of the announced amendments to the tax consolidation rules include the following:
- the consolidation tax cost setting rules will not apply to potentially duplicate tax deductions for the same ultimate owner in circumstances where a non-resident disposes of membership interests in a non-land rich entity to a tax consolidated group;
- certain deductible liabilities included in step 2 of the entry tax cost setting calculation are not taken into account twice, by including an amount in the acquiring head company’s assessable income over a 12 month or 48 month period (depending upon whether the deductible liability is a current or non-current liability); and
- consolidated groups cannot access double benefits by shifting the value of assets between entities (ie, in circumstances where an encumbered asset, whose market value has been reduced due to the intra-group creation of rights over the encumbered asset, is sold by a consolidated group, whether directly or indirectly).
Further specific amendments will be made to the interaction between to the taxation of financial arrangements (TOFA) provisions and the tax consolidations rules, for example only net gains and losses will be recognised for tax purposes for certain intra-group liabilities and assets between a continuing member of a tax consolidated group and an exiting member of a tax consolidated group.
On Budget night, Treasury also released an Issues Paper entitled “Removing the tax advantages available to multiple entry consolidated groups”, announcing that it will legislate amendments ensuring multiple entry consolidated (MEC) groups (broadly tax consolidated groups with multiple Australian companies which are owned from offshore) do not have access to tax benefits unavailable to domestic consolidated groups. The Assistant Treasurer also announced that the Government reserves the right to take earlier legislative action if it becomes aware of any aggressive tax minimisation practices over the course of a tripartite review to be established between Treasury, the ATO and the private sector. The Government announced that it will consider any evidence of aggressive tax planning to include, but not be limited to, a significant number of:
- foreign-owned ordinary consolidated groups transitioning to MEC groups;
- MEC groups flattening their structures (eg, by incorporating new tier-1 companies or by lifting low-level subsidiaries up to the tier-1 level); and
- consolidated groups transferring subsidiaries to MEC groups with the same ultimate owner.
One current benefit of the MEC provisions which the Government is focussed on is the fact that MEC groups can effectively choose whether the tax basis in assets of acquired entities are reset to market value (by making the acquired entity a subsidiary of one of the existing Australian MEC group members) or are preserved at their legacy amounts (by having the acquired entity owned from offshore but joining the MEC group). This feature of the existing laws means that MEC groups can effectively choose not to the reset tax basis of assets of acquired entities in circumstances where such resetting would result in a loss of tax basis in the acquired entity’s assets.
Many of the announced measures are highly tailored to specific factual scenarios, and we query whether they are all strictly necessary in light of Australia’s comprehensive (and recently improved) general anti-avoidance rules. The net effect of these amendments, if enacted, would appear to us to make an already highly complex set of tax rules even more complicated.
Deferral of deductions relating to mining information
The immediate deduction for the cost of assets first used for exploration will be tightened by excluding mining rights and information. Under the proposals, mining rights and information first used for exploration will be depreciated over 15 years, or their effective lives, whichever is shorter. The effective life of a mining right and associated exploration information will be the life of the mine that it leads to. If the exploration is unsuccessful, the remaining amount will be written off when this fact is established. Despite the above, the following amounts will continue to be immediately deductible:
- costs of mining rights from a relevant government issuing authority;
- costs of mining information from a relevant government authority;
- costs incurred by a taxpayer itself in generating new information or improving existing information; and
- mining rights acquired by a farmee under a recognised “farm-in farm-out” arrangement.
The measures will apply to taxpayers who start to hold the mining right or information after 7:30pm AEST on 14 May 2013 unless the taxpayer is committed to the acquisition of the right or information (either directly or through the acquisition of an entity holding the asset) before that time or they are taken by tax law to already hold that right or information before that time.
This will have a significant impact for taxpayers in M&A transactions amongst other things, for example where a consolidated group acquires shares in an exploration company and resets the tax basis of the underlying assets on acquisition, previously an immediate deduction would have been available to the acquirer. This will no longer be the case.
Amendments to the Venture Capital Limited Partnership (VCLP) and Early Stage Venture Capital Limited Partnership (ESVCLP) regimes
As previously announced by the Assistant Treasurer on 18 February 2013, the Government will make changes to the VCLP and ESVCLP regimes following recommendations made by the Board of Taxation. These measures are forecast to have a small but unquantifiable cost to the revenue.
Specifically, the Government will:
- deem gains or losses made by a VCLP on the disposal of an eligible venture capital investment held for 12 months (which flow through to the partners) to be on capital account;
- lower the minimum investment capital required for entry into the ESVCLP program from $10 million to $5 million to facilitate increased funding from "angel" investors; and
- phase out the Pooled Development Fund (PDF) program over a number of years in consultation with stakeholders. The PDF program has been closed to new registrants since 2007.
These measures are welcomed, as they not only provide certainty in relation to the often ephemeral revenue / capital distinction, but they also potentially open up the ESVCLP concessions to a wider category of investors and investments (which is in keeping with the policy objectives of the ESVCLP regime, namely promoting investment in emerging and often new-technology businesses).
ATO Compliance Checks on Off-shore Marketing Hubs and Business Restructures
The Government has said that it will provide over $109 million over four years to the ATO to increase compliance activity targeted at restructuring activity that facilitates profit shifting opportunities. It is hoped that this will increase revenue by $576.5 million over the forward estimates period.
Crackdown on abuse of trusts
The Government has announced extensive funding ($67.9 million over 4 years) of the ATO to enable it to undertake increased compliance activity of complex tax structures by high net worth individuals who have exploited trusts to conceal income, adopt contrived loan arrangements, mischaracterise transactions, artificially reduce trust income and underpay tax.
In announcing the measure, the Government said that will focus the compliance activity on known tax scheme designers and promoters, as well as individuals and businesses who participate in such activity. It expects that such a crackdown will have a deterrent effect and encourage compliance by the wider community.
The Government has also said it will use information from the crackdown to inform the next phase of the reform of the taxation of trusts and beneficiaries. The Assistance Treasurer has also said that he will ask Treasury to consult with the ATO’s National Tax Liaison Group (NTLG) on reforms to address integrity concerns arising from the mismatch of trust and tax concepts of income.
Extension of monthly PAYG instalment regime to other large entities
All large entities in the Pay As You Go (PAYG) instalment system, including trusts, superannuation funds, sole traders and large investors will now be required to make monthly PAYG income tax instalments. This measure will have the effect of bringing forward tax payments which otherwise would have only been required on a quarterly basis. This will therefore necessitate changes to the systems employed by these entities in order to ensure compliance with the new regime, as well as having cash-flow implications for non-corporates.
Amendments to Offshore Banking Unit (OBU) regime
Under proposed amendments which will be effective for income years commencing on or after 1 July 2013:
- dealings between related parties, including the transfer of transactions between an OBU and a related domestic bank, will be ineligible for OBU treatment;
- transactions between OBUs, including between unrelated OBUs, will be ineligible for OBU treatment;
- other provisions of the income tax law will be amended so as to interact with the OBU provisions appropriately; and
- the current list of eligible OBU activity will be tightened.
Furthermore, the Government proposes to consult with industry to develop recommendations to address concerns with the allocation of expenses between OBU and non-OBU activities and on issues raised by the Johnson Report.
The view from Government is that stronger integrity rules are required to prevent banks from shifting their domestic banking activities and profits into OBUs rather than attracting new mobile activity. An example given is of banks using complex arrangements to shift ineligible income into the OBU to attract a concessional 10% tax rate while at the same time seeking to ensure any losses or deductions remain in the domestic operations to be deducted at the normal 30% tax rate.
Tax information exchange agreement (TIEA) with the Oriental Republic of Uruguay
The Government announced that it signed an information exchange agreement with Uruguay on 10 December 2012 but it is still subject to formal ratification and domestic law implementation (both in Uruguay and Australia).
As with other agreements of this nature, the agreement will provide for the sharing of tax information between Australia and Uruguay.
Once implemented, the TIEA will also allow for certain Australian domestic law exemptions to become available to Uruguayan residents, such the concessional Managed Investment Trust withholding tax of 15%.
‘Dividend Washing’ measures
The Government will target sophisticated investors engaged in ‘dividend washing’ from 1 July 2013. The mischief being targeted is a particular form of trading in franking credits which can result in some shareholders receiving two sets of franking credits for effectively the same parcel of shares. An example of this is where an investor sells shares with a dividend and then immediately buys equivalent shares that still carry a right to a dividend. Under the proposed measures they will only be entitled to use one set of franking credits. The changes will be targeted to the two day period after a share goes ex-dividend.
Clarification of Tax Treatment of Native Title Benefits
The Government has announced that no capital gains or capital losses will arise from the transfer on or after 1 July 2008 of Native Title Rights or the right to a Native Title Benefit to an Indigenous holding entity or Indigenous person, or from the creation of a trust that is an Indigenous Holding Entity over such rights. Furthermore capital gains or losses made from surrendering or cancelling such rights are to be disregarded.