Posted on 1st February 2017 by Ashley Dawson
Thin Capitalisation is the excessive use of debt finance compared to equity finance. For example, if an organisation were to have a debt to equity ratio 3:1 for every $3 of debt the entity is funded by $1 of equity.
The intention of Division 820 in the ITAA97 is to prevent multinational entities from shifting profits outside of Australia by funding their Australian operations with a high amount of debt finance in order to reduce their Australian tax liability.
The thin capitalisation rules act to limit the amount of debt deductions that an entity can otherwise deduct from their assessable income where the debt to equity ratios exceed the prescribed limits i.e. the entity is “thinly capitalised”.
Division 820 applies to foreign controlled Australian entities, Australian entities that operate internationally and foreign entities that operate in Australia.
Please note this Division does not apply to assets or non-debt liabilities that are held wholly or principally for private or domestic use.
A debt deduction is a cost incurred in connection with a debt that would otherwise be deductible (e.g. interest expense and borrowing costs), this specifically excludes salary or wages, rental expenses and foreign currency losses.
Debt deductions will be allowed if the total debt deductions for an entity and its associated entities does not exceed $2 million in an income year (from 1 July 2014, the previous threshold was $250,000).
The thin capitalisation rules will also not apply to outward investing Australian entities if at least 90% of their assets (including those of their associates) are Australian assets.
The application of the rules varies depending on the type of entity and whether they are inwards or outwards investors of Australia.
For a non-authorised deposit-taking institution (ADI) general entity, the following tests (among others) are available to determine the amount an entity’s debt deductions will need to be reduced by:
- Safe Harbour Debt Test
The amount of debt used to finance the Australian investments will be treated as excessive when it is greater than a debt to equity ratio of 1.5:1 or 3/5 (commencing from 1 July 2014).
- Arm’s Length Debt Test
This is determined by analysing the entity’s activities and funding to determine the amount the entity could reasonably expect to borrow on arm’s length terms from a third party.
If you think you may be affected by the Thin Capitalisation rules and wish to discuss further, please contact our office.