Thin capitalisation

What is thin capitalisation and why is it a problem?

Thin capitalisation occurs when a multinational entity finances its Australian operation with a lot of debt compared to its equity. When this happens, the multinational entity’s equity capitalisation in Australia is said to be ‘thin’. You will appreciate that a multinational entity may want to do this because debt generates interest deductions, whereas dividends from equity do not.

Further, the effective rate of tax on interest may be more favourable than dividends. This allows the multinational entity to shift profits: by loading deductible expenses in Australia, profit is shifted elsewhere, usually to a lower taxing jurisdiction.

In the absence of special rules, it is generally more tax effective for entities with investments to allocate a disproportionate and excessive amount of debt to their Australian operation. The effect of this is that it maximises their income tax deductions in Australia, which in turn minimises their Australian income tax liabilities.

 Who are affected or subject to the thin capitalisation rules?

The thin capitalisation rules affect:

  • Australian entities with certain overseas operations, and their associate entities (outward investors)
  • Australian entities that are foreign controlled (inward investors)
  • foreign entities with operations or investments in Australia that are claiming debt deductions (inward investors).

The thin capitalisation rules apply to all Australian entities which includes, but is not limited to, companies, partnerships, trusts, and individuals.

There are number of situations where thin capitalisation rules do not apply:

  1. where an entity does not have any debt deduction for the income year;
  2. where the debt deductions for an entity and its associates are $2 million or less for the income year;
  3. where an Australian resident entity is neither an inward investing entity nor an outward investing entity. For example: it is a wholly onshore operations.
  4. Where a foreign entity has no investment or presence in Australia. For example: it is a wholly offshore operation.

From 1 July 2014, a series of amendments were made to tighten the thin capitalisation rules for affected entities. The amendments are summarised below.

  • The ATO tightened the safe harbour limits. For general entities (i.e., excluding banks and financial entities) the safe harbour reduced from 3:1 to 1.5:1 on a debt to equity basis. In other words, the debt to equity ratio was decreased from 75% to 60%.
  • The worldwide gearing ratio for outbound investors was reduced from 120% to 100%.
  • The de minimis threshold from $250,000 to $2 million of debt deductions. This prevented many SMEs from having to comply with the thin capitalisation rules. However, the transfer pricing provision may still need to be considered when it comes to funding arrangements with either foreign investors or foreign subsidiaries.

What are the consequences if thin capitalisation rules apply?

To the extent that the entity’s adjusted average debt exceeds its maximum allowable debt, the debt deductions are proportionately denied. The maximum allowable debt depends on the type of entity (e.g. Outward investing entity, Inward Investor, and Inward investment vehicle).

Please note you must consider the thin capitalisation rules each year. For further details, please reach out to us.