Thin capitalisation provisions

'Thin capitalisation'' rules that operate to restrict the deductibility of interest paid by an Australian enterprise on debts owing by it to certain non-residents or dual residents have been incorporated in the income tax legislation for many years.

New rules applicable from 1 July 2001 introduced a completely new thin capitalisation regime. The new regime is intended to be more effective in preventing an excessive allocation of debt, for tax purposes, to the Australian operations of multinationals and to ensure that Australia obtains a fair share of tax from those who operate internationally.

Under the new regime the operation of the thin capitalisation rules has been extended to the total debt of the Australian operations of both inward- and outward-bound multinational groups (including branches of those groups). Generally, interest deductions are denied to the extent the debt to equity ratio of the Australian operations of inward-bound foreign multinationals or outward-bound Australian multinationals exceeds 3: 1.

Gearing ratios in excess of 3: 1 are permitted without penalty for multinationals that can satisfy an arm's length test for debt levels of their Australian operations. Separate rules apply for banks and financial institutions.

Small to medium sized enterprises

To reduce compliance costs for small and medium enterprises, the new regime does not apply to taxpayers or groups of taxpayers claiming annual debt deductions (e.g. interest expenses) of $250,000 or less.

The rules also allow Australian branches of foreign companies to borrow internationally without having to pay withholding tax on the subsequent interest payments.

Debt/equity rules

In conjunction with the commencement of the new thin capitalisation regime, the Government also introduced a new approach for determining what constitutes equity in a company and what constitutes debt in an entity.

The new rules set out the debt/equity borderline for tax purposes and determine whether returns on interest may be frankable as dividends or may be deductible.

The test for distinguishing debt interests from equity interests focuses on a single organising principle - the effective obligation of an issuer to return to the investor an amount at least equal to the amount invested. The Government in introducing the rules stated that this test seeks to minimise uncertainty and provide a more coherent, economic substance based test that is less reliant on the legal form of a particular arrangement.

There is an extended definition of equity based on economic substance (broadly speaking, interests that raise finance and provide returns contingent on the economic performance of a company constitute equity, subject to the debt test). The definition of debt interest in these rules is also used for the purpose of the new thin capitalisation regime.

More information

Full details of the thin capitalisation provisions and details of relevant legislation can be found can be found in the Australian Taxation Office's thin capitalisation guide. Further details of the debt/equity rules can be found in the Guide To The Debt Equity Tests.