Thinly capitalised entity
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.
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.
This explains the thin capitalisation rules and which entities they affect, outlines key concepts, and shows how to categorise entities to apply the rules.