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  • Thin capitalisation

    A thinly capitalised entity is one whose assets are funded by a high level of debt and relatively little equity. An entity's debt-to-equity funding is sometimes expressed as a ratio. For example, a ratio of 1.5:1 means that for every $3 of debt, the entity is funded by $2 of equity. This is also known as 'gearing'. An entity that is highly geared funds its assets with proportionately more debt than equity.

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    COVID-19 and thin capitalisation

    The recent disruption brought about by COVID-19 may affect not only taxpayers' compliance with their reporting obligations, but also the underlying economic fundamentals that inform the choice of method for calculating maximum allowable debt for thin capitalisation purposes.

    In line with our recent announcements about support for businesses affected by COVID-19, we understand this is a time of significant uncertainty and we will need to be flexible in how we administer our approach to compliance.

    Simplified approach to the arm’s length debt test (ALDT)

    For the tax years encompassing the February and March 2020 period (the relevant year), if you are a non-ADI taxpayer you may no longer be able to rely on the safe harbour or worldwide gearing tests to determine your maximum allowable debt as a result of balance sheet effects brought by COVID-19. These balance sheet effects may be as a result of impairment of asset values or short-term draw downs on debt facilities as a direct result of COVID-19. If so, you may wish to consider the following for the affected income year.

    For the purpose of calculating average values for thin capitalisation amounts, the selection of alternative valuation measurement periods may allow a degree of smoothing of values in situations where wide variations have occurred throughout the income year.

    The table below demonstrates an example of the effect different measurement periods may have. In this example, monthly average has been selected.

    Example – effect of the different measurement periods

    Period

    Jul

    Aug

    Sep

    Oct

    Nov

    Dec

    Jan

    Feb

    Mar

    Apr

    May

    Jun

    Avg.

    Opening or closing

    $100

    -

    -

    -

    -

    -

    -

    -

    -

    -

    -

    $60

    $80

    Periodic (monthly)

    $100

    $100

    $100

    $100

    $100

    $100

    $90

    $80

    $80

    $70

    $60

    $60

    $86.60

    Other options available

    While the facts and circumstances will vary for each taxpayer, we encourage you to explore the use of all the alternative measurement periods in testing the suitability of the safe harbour or worldwide gearing tests.

    If you will otherwise need to rely on the arm’s length debt test (ALDT) for the relevant year, as a direct consequence of COVID-19, you can expect we will not dedicate compliance resources to reviewing the application of ALDT if the requirements listed below are met, other than to verify that the use of the test was directly related to a COVID-19 reflex.

    The requirements for the simplified ALDT approach include:

    • You would have satisfied the safe-harbour test but for the COVID-19 related balance sheet effects.
    • It is still expected that you will use best endeavours to apply all criteria of the ALDT.
    • For entities that are classified as inward investing entities (and not also outward investing entities) our compliance approach (as outlined above) applies only to the extent that no additional related party funding is received, other than short-term (less than 12 months) debt facilities. In these instances, we would expect any new capital to be equity.
    • We would not expect inward investing entities to require the use of ALDT because dividends were paid, thereby weakening the Australian balance sheet.

    If your economic circumstances are expected to persist over the longer term and, as a result, you are likely to rely on the ALDT beyond the immediate income tax year, take the opportunity to discuss your circumstances with us.

    You can also expect that we will take a balanced approach to matters such as record keeping and timing of the creation of records for the purposes of the test. You should attempt to prepare documents supporting the application of the ALDT, but we will not apply compliance resources to determine if the documents satisfy the standards set out in Draft Practical Compliance Guideline PCG 2019/D3 ATO compliance approach to the arm's length debt test.

    We are committed to working with you and your advisors to provide certainty in these challenging times. We have a dedicated team responsible for the oversight and management of thin capitalisation risks. If you wish to discuss your application of the ALDT with us, you may contact Shahzeb Panhwar, Assistant Commissioner, International Tax Structuring at International@ato.gov.au. Alternatively, if you have a dedicated relationship manager you may approach them directly for assistance with your case.

    Thin capitalisation rules

    Under the thin capitalisation rules, the amount of debt used to fund the Australian operations of both foreign entities investing into Australia and Australian entities investing overseas is limited. The rules disallow a deduction for a portion of specified expenses an entity incurs in relation to its debt finance; that is, its debt deductions. The rules apply when the entity's debt-to-equity ratio exceeds certain limits.

    A debt deduction is an expense an entity incurs in connection with a debt interest, such as an interest payment or a loan fee that the entity would otherwise be entitled to claim a deduction for. Certain expenses are excluded from being debt deductions under tax law, including rental expenses on certain leases and some foreign currency losses.

    Examples of debt interests include loans, bills of exchange, or a promissory note. Generally, interest free debt does not count as part of an entity's debt.

    The thin capitalisation rules affect both Australian and foreign entities that have multinational investments. This means they apply to:

    • Australian entities with specified overseas investments – these entities are called outward investing entities
    • foreign entities with certain investments in Australia, regardless of whether they hold the investments directly or through Australian entities – these entities are called inward investing entities.

    There are two threshold tests that ensure entities with relatively small debt deductions or small overseas investments are not subject to the thin capitalisation rules. There is also a third test for certain entities established to manage certain risks.

    You will not be affected by the thin capitalisation rules for any given income year if you satisfy one of the following tests:

    • You are an Australian resident entity that is not an inward investing entity nor an outward investing entity.
    • You are a foreign entity that has no investments (such as assets) or permanent establishment in Australia.
    • You meet any of the three threshold tests  
      • Your debt deductions, together with those of any associate entities, are $2 million or less for the income year.
      • You are an outward investing entity that is not also foreign controlled and you meet the assets threshold test.
      • You are a special purpose entity established to manage certain risks.
       

    Remember, you must consider the thin capitalisation rules each year.

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    Last modified: 29 Jul 2020QC 17057