Thin capitalisation ratios to come down?

Thin capitalisation ratios to come down?

Geoffrey Yiu and James Macky assess the potential impact of a rumoured reduction to the thin capitalisation limit in the upcoming Federal Budget.

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A harbour at night time, with lights from boats on the water and buildings on the land visible.

This week, major newspapers have reported a Federal Budget "advertising ‘leak’ showing $16 billion in savings over the next four years”. 

One of the changes reported to be pursued by the Government concerns multinational tax avoidance and, under that umbrella, is a rumoured reduction of the 'safe harbour' thin capitalisation limit from 60 percent to 50 percent of assets.

If the safe harbour ratio does come down, or if your organisation is otherwise at its thin capitalisation limit, a number of strategies can be pursued. As 30 June approaches, it is probably a good time to review your thin capitalisation strategy anyway.

One of the most common approaches to thin capitalisation is for management to consider swapping debt for equity. However, such a strategy may only result in replacing non-deductible interest with non-deductible dividends, with no consequential impact on the organisation’s Australian income tax position.

Generally, groups should only implement such a strategy if it results in a different global tax position, taking into account factors such as Australian withholding tax and the parent company’s ability to claim a credit; the parent company’s tax rate and access to exemptions on interest and dividends; the parent company’s own limitations on interest deductibility; as well as the group’s cost of capital.

Australia’s commercial debt forgiveness, share capital tainting and capital injection rules also need to be managed.  

In working through your thin capitalisation strategy, the following methodology may be useful:

  • Explore exemptions: exemptions include the $2 million de minimis, and 90 percent assets in Australia test (for outbound investors).  Exclusions and concessions also apply to finance companies and securitisation vehicles. 
  • Consider alternative methodologies: alternative methodologies to the safe harbour method include the 'worldwide gearing test', which is now available to both inbound and outbound groups, and the 'arm’s length debt test'.  These alternative methodologies can result in much higher gearing levels than the safe harbour method. 
  • Refine the calculation: this can include testing conservative assumptions, particularly around the classification of liabilities as between debt capital and non-debt liabilities, as well as ensuring expenses such as hedge costs are not inadvertently included in the pool of debt deductions to be denied.  It can also be advantageous to choose measurement days (for averaging purposes) that capture points in time when asset values are relatively high (as opposed to impaired), and conversely, ensure periods of higher debt are not over-represented in the averaging. 
  • Revalue assets: assets can be revalued for thin capitalisation purposes within prescribed parameters and applying accounting standard principles. Specialist accounting and tax advice is usually required if revaluing assets for thin capitalisation purposes, noting the nature and extent of permissible revaluations are not usually performed for financial statement purposes, and such revaluations are a current focus of the Australian Taxation Office. 
  • Refinance: consider the mix of debt to equity and refinancing options, taking into account the global factors noted above. 

Finally, consideration should be given to the alignment and flexibility of your thin capitalisation strategy to other changes in the tax landscape that can impact structuring and financing, such as the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting action plan and the multi-national anti-avoidance legislation.

Is it time to review your thin capitalisation strategy?

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