The Australian thin capitalisation rules are in a state of flux with changes proposed to the “safe harbour” test, a current review of the “arm’s length debt” test and possible changes proposed to the “worldwide gearing” test.
What does the current landscape mean for planning for the future?
The tax deductibility of interest (and other debt related expenditure) may be an important consideration in determining the income tax expense of a business. Multinationals with operations in Australia (those either controlled by inbound investors and/ or Australian entities with controlled outbound investments) need to make this determination through the prism of the Australian thin capitalisation rules.
The Australian thin capitalisation rules contained in Division 820 of the Income Tax Assessment Act 1997 (Cth) operate to deny debt deductions to certain multinationals with operations in Australia to the extent that their “adjusted average debt” exceeds their “maximum allowable debt”. The policy behind the rules is to prevent multinationals allocating an excessive amount of debt to their Australian operations.
A taxpayer’s maximum allowable debt is determined by reference to the greater of the “safe harbour debt amount” and the “arm’s length debt amount” and, for certain taxpayers, the “worldwide gearing debt amount”.
The “safe harbour” test
Many multinationals will focus their attention on whether they satisfy the “safe harbour” test. This is natural considering that the “safe harbour debt amount” is objectively measurable under a specific legislative formula. Coming within the safe harbour debt amount means that there is no need to explore in any detail whether the “arm’s length debt amount” or the “worldwide gearing debt amount” could produce a greater maximum allowable debt.
On 6 November 2013, the current Coalition government confirmed that it would proceed with a number of announced, but unlegislated, tax measures. One such measure was the proposal announced by the former Labor government as part of the 2013/14 Federal Budget to amend the thin capitalisation rules to reduce the “safe harbour debt amount” from the current 3:1 debt to equity ratio to 1.5:1 (ie a reduction from 75% to 60% of average Australian assets). The proposed amendments are expected to apply to income years commencing on or after 1 July 2014.
The Australian operations of multinationals may end up highly geared for a number of reasons. For example, a transformative M&A transaction may have been funded predominantly by debt. For any such entity that is currently within the safe harbour, it will be necessary to consider:
- Will the current finance structure result in excessive debt under the new safe harbour debt amount?
- If so, what hurdles are there to restructuring the financing to come within the new safe harbour? The proposed amendments do not contain any grandfathering rules that would allow the current debt to equity ratios to continue to apply to existing financing arrangements.
It will be important to consider whether debt facilities already in place and spanning the commencement of the new rules have any in-built flexibility to accommodate the changes (eg do they allow debt to be repaid without penalty from the proceeds of an equity raising?).
- Is there scope to revalue a group’s underlying Australian assets which may result in an increased safe harbour debt amount when using the new ratios?
- What is the risk of the income tax general anti-avoidance rule (GAAR) applying to any debt restructure? In a National Tax Liaison Group consultative workshop on the recently amended GAAR, the Australian Taxation Office (ATO) flagged its view that the GAAR may apply in such circumstances. However, the fact that the reforms are yet to be enacted may be a hurdle for the ATO in applying the GAAR.
For taxpayers that already exceed the safe harbour debt amount, or would be likely to do so under the new ratio, it will be necessary to consider whether recourse may be had to the “arm’s length debt” test.
The “arm’s length debt” test (ALDT)
For multinationals that may find themselves with debt exceeding the “safe harbour debt amount” once it is reduced from the current 3:1 debt to equity ratio to 1.5:1, the ALDT will gain a new prominence.
The ALDT is an alternative test and is directed towards determining whether the level of debt is commercially justifiable having regard to the amount that the entity would be reasonably expected to have borrowed – and an independent lender would have lent – in the relevant circumstances, subject to some modifications.
For those multinationals seeking to rely on the ALDT, the current test is onerous and brings with it considerable compliance costs. Uncertainty arises due to the subjective nature of the test and the risk of taxpayers and the ATO forming different conclusions regarding the commercially justifiable debt levels.
The previous government commissioned a review of the ALDT by the Board of Taxation and, on 16 December 2013, the Board released a Discussion Paper in this regard.
The Board’s review is focused on:
- How to reduce the compliance burden for taxpayers when determining their arm’s length debt amount.
- How to reduce the burden on the ATO in administering the ALDT.
- Whether there should be restrictions on eligibility to use the ALDT.
Measures to reduce the cost to taxpayers in assessing their ability to rely on the ALDT will be welcomed by multinationals with Australian operations. Of particular interest is the floating of:
- A move from annual testing of the ALDT to a singular test at the time of the relevant borrowing (subject to a reassessment where there is material change to the arrangements).
- Additional safe harbour tests based on earnings (eg EBITDA). The paper acknowledges that this may subject certain taxpayers to lumpy thin capitalisation positions depending on cyclical factors or abnormal profit and loss movements.
- Simplification of the ALDT in circumstances where there is no related party debt.
- Allowing a consideration of credit support from related parties where such support is consistent with ordinary commercial dealings.
- A system of advance thin capitalisation agreements between a taxpayer and the ATO. There is already a precedent in Australia for such arrangements, namely advance pricing arrangements for transfer pricing purposes.
One particular policy discussion that should continue to be monitored is that regarding any limitations on eligibility to apply the ALDT. In framing the issues on which the Board of Taxation has sought input, the discussion focused on the particular needs of capital intensive industries, large scale projects and the property sector. The attention given to such sectors seems to suggest that there is recognition at a policy level that they are more likely to need to rely on the ALDT. However, the difficulties will concern how eligibility is to be narrowed and then how the relevant sectors will be defined.
Stakeholders, especially those in capital intensive industries that are more likely to need recourse to the ALDT, should continue to monitor the development of the proposed changes to the ALDT after the Board of Taxation completes its review (noting that submissions closed on 14 March 2014).
The “worldwide gearing” test
The “worldwide gearing” test may also be of assistance when determining a multinational’s maximum allowable debt, but it is generally only available for entities that are not foreign controlled. This test effectively enables the entity to be geared to a ratio up to 120% of the actual gearing of the entity (including the group that it controls).
Changes announced in the 2013/14 Federal Budget and adopted by the current government propose to extend the scope of the worldwide gearing test to make it available to inbound investing entities, but would be coupled with a reduction in the gearing ratio from 120% to 100%. The proposed amendments are expected to apply to income years commencing on or after 1 July 2014.
Where to from here?
The Australian thin capitalisation landscape is clearly evolving rapidly. Stakeholders should:
- Assess the impact, if any, of the proposed amendments to the “safe harbour debt” test on the financial arrangements for their Australian operations.
- Review current finance arrangements to determine whether they are flexible enough to make changes to accommodate the new safe harbour debt ratios.
- Continue to monitor the development of the proposed changes to the ALDT after the Board of Taxation completes its review.
- For inbound investing entities, monitor the developments in respect of the worldwide gearing test and determine whether there may be an opportunity to avail themselves of that test (if required) if it is extended as proposed.