The Government announced that it would address profit shifting by multinationals through the disproportionate allocation of debt to Australia by tightening and improving the integrity of several aspects of Australia’s international tax arrangements, with effect for income years commencing on or after 1 July 2014. The Government expects this to have an estimated gain to revenue of id=”mce_marker”.5bn over the forward estimates period.
The Government said its action in announcing the measures was consistent with the OECD’s approach on base erosion and profit shifting and the Government’s role in the G20’s multilateral action to address base erosion and profit shifting.
The Treasurer said the Government will release a Treasury Scoping Paper in June 2013 to examine the risks to the sustainability of Australia’s corporate tax base from base erosion and profit shifting.
In particular, the changes announced in the Budget will involve:
- tightening and improving the effectiveness of the thin capitalisation rules including changing all safe harbour limits;
- extending a worldwide gearing test to inbound investors;
- increasing the de minimis threshold from $250,000 to $2m of debt deductions which is designed to reduce compliance costs for small business;
- better targeting the exemption for foreign non-portfolio dividends received by Australian companies; and
- removing the provision allowing a tax deduction for interest expenses incurred in deriving certain exempt foreign income.
Thin capitalisation changes
The Assistant Treasurer said the thin cap rules would be changed by tightening all safe harbour limits as follows:
- for general entities, the limit will be reduced from 3:1 to 1.5:1 on a debt to equity basis (or 75% to 60% on a debt to total asset basis);
- for non-bank financial entities, the limit will be reduced from 20:1 to 15:1 on a debt to equity basis (or 95.24% to 93.75% on a debt to total asset basis);
- for banks, the capital limit will be increased from 4% to 6% of their risk weighted assets of the Australian operations;
- for outbound investors, the worldwide gearing ratio will be reduced from 120% to 100% (with an equivalent change to the worldwide capital ratio for banks.
The Government said it will consult with industry on the implementation of these proposed changes. In addition, the Board of Taxation will conduct a review of the thin capitalisation arm’s length [debt levels] test. The ATO will also commence consultation with taxpayers and industry to progress any guidance material in relation to these changes.
Background to the thin cap rules
The thin capitalisation regime aims to limit the capacity of multinational firms to move profits out of Australia by assigning an excessive amount of debt to their Australian operations. When the Australian subsidiary’s borrowing exceeds a defined threshold, its interest expenses can no longer be deducted from its income. The regime applies to all of the debt of a relevant multinational and not just to the debt borrowed from foreign related parties.
Australian subsidiaries can apply one of a number of thresholds under the rules, including: [1] the “safe harbour” limit, [2] the “arm’s length” debt limit and [3] for outward investors, a worldwide gearing ratio limit – see below. Different safe harbour limits apply to “general entities”, non-bank financial entities and banks.
In its August 2012 discussion paper looking at ways of making “revenue neutral” cuts to the company tax rate, the Business Tax Working Group (BTWG) noted that, “when assessed against other countries’ thin capitalisation regimes, the Australian rules could be seen as overly generous”.
The BTWG also noted there were flaws with particular rules, including the arm’s length test (particularly when it does not have a firm-specific element), which in its current form could allow significant profit shifting to occur. As a discretionary test, moreover, it is difficult for the ATO to administer, the BTWG said. The large information asymmetry that third parties face when auditing (or potentially auditing) tax calculations that can be based on subjective market and firm-specific information and assumptions raises integrity concerns, the Group also pointed out.
According to the BTWG: “It should also be kept in mind that the gearing levels these rules allow are higher than the levels employed by those firms that have little capacity/incentive to shift profits out of Australia (that is, purely domestic firms or firms that rely on truly independent financing arrangements). This gives multinationals a tax advantage over their Australian market competitors.”
Thin capitalisation describes circumstances in which a taxpayer has cross-border investments and the taxpayer’s allowable interest deductions are limited by a specified statutory ratio or formula. This limit is imposed with the aim of countering the strategy of using debt over equity funding so as to obtain the more favourable tax treatment of debt. The thin cap rules are contained in Div 820 of the ITAA 1997.
Interest deductions denied under the thin cap rules cannot be added to the cost base of a CGT asset.
Under the current Div 820:
- both inward and outward investors are covered. Division 820 can have serious potential consequences for a foreigner operating a business within Australia and an Australian operating a business offshore if interest is claimed against Australian assessable income;
- deductions are limited by reference to the total debt of the Australian operations of those investors, rather than foreign debt only; and
- a de minimis rule can apply. Where an entity’s debt deductions (and those of its associates) do not exceed A$250,000, Div 820 will have no impact.
Where Div 820 applies, the result is that if the thin capitalisation trigger has been activated, some of the debt deductions which would otherwise be available will be denied.
For a non-authorised deposit taking institution, debt deductions will be denied if the amount of debt used to fund the entity’s Australian operations exceeds the allowed maximum amount of debt. For an authorised deposit taking institution (eg a recognised bank), debt deductions will be denied if the equity capital used to fund its Australian operations is less than the minimum equity requirement.
A so-called “outward investor (general)” is essentially an Australian resident entity (that is not a financial entity) which either controls a foreign resident entity or carries on a business at or through a permanent establishment (PE) overseas. Such an entity is required to calculate its “adjusted average debt” and compare it to its “maximum allowable debt”. If its adjusted average debt exceeds the maximum allowable debt, there is a proportionate denial of the debt deductions otherwise available to the entity. If not, there are no thin capitalisation adjustments. Under the current rules, the maximum allowable debt is the greatest of the following 3 debt amounts:
- the safe harbour debt amount, ie 75% of the average net value of the assets of the entity plus any surplus value in associated entities – giving a 3:1 debt/equity ratio;
- the arm’s length debt amount (ie the amount of debt that would have been borne by an independent party operating under the same conditions and terms); and
- the worldwide gearing debt amount (up to 120% of the gearing of an outward investor’s Australian investments and foreign investments that it controls).
Board of Taxation reviews
The Treasurer said the Board of Taxation will undertake 2 reviews:
- The Board will examine the arm’s length test as it applies to the thin capitalisation rules to make it easier to comply with and administer, and to clarify in what circumstances the test should apply.
- The Board will also combine a post-implementation review of the debt and equity rules with a review of whether there can be improved arrangements within the Australian tax system to address any inconsistencies between Australia’s and other jurisdictions’ debt and equity rules that could give rise to tax arbitrage opportunities.
The Government said the terms of reference for these reviews will be released in the coming weeks.
Exemption re foreign non-portfolio dividend income – s23AJ to be amended to apply to non-portfolio ‘equity interests’ including through trusts etc.
The Assistant Treasurer said the reforms to the exemption available to Australian companies for their foreign non-portfolio dividend income (ie returns to Australian entities on the equity interests greater than 10% that they hold in foreign entities) announced in the 2009-10 Budget would be implemented as part of its corporate tax base protection package.
The exemption is intended to apply to returns on foreign non-portfolio equity interests. The proposed amendments are designed to ensure that the exemption operates as intended and is not available to returns on debt interests or interests that are truly portfolio in nature.
The exemption will also be expanded so that it applies where an Australian company receives foreign non-portfolio dividend income through an investment in a trust or partnership.
Deduction re foreign exempt income – s25-90 deduction for interest incurred to derive exempt income to be abolished (a very retrograde measure)
The Government announced that the ‘concession’ [s25-90 of the ITAA97] that allows a tax deduction for interest expenses incurred in deriving certain foreign exempt income will be removed. The Assistant Treasurer said “it is now clear that this concession is being abused”.
[Section 25-90 gave taxpayers allowed ‘debt deduction’ on ‘debt interests’ incurred to derive income from a foreign source that was ‘*non-assessable non-exempt’ under s23AI, s23AJ or s23AK of the ITAA36. The most common occasion it operated was when an Australian company borrowed money to capitalize a foreign wholly owned subsidiary. Quite what could be ‘abusive’ about this is entirely unclear, and in the author’s opinion, this measure should be reversed or better targeted to what ever the real abuse was.]
CFC measures
The Assistant Treasurer said the OECD recognised CFC rules as a key “pressure area” in its work on base erosion and profit shifting. He said the CFC rules reduce the incentive for businesses to adopt aggressive restructuring arrangements to shift profits.
Therefore, the Government announced that the remaining reforms to the CFC rules and foreign source income attribution rules announced in the 2009-10 Budget would “be reconsidered after the OECD’s analysis is completed”.
Treasury paper released
A Treasury proposals paper outlining these changes was released on Budget night and is available on the Treasury website.
Source: Budget Paper No 2 [p 33]; Treasurer’s press release, 14 May 2013
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