House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 11 - Regulation impact statement

Policy objective

The objectives of the New Business Tax System

11.1 The measures in this bill are part of the Governments broad ranging reforms which will give Australia a New Business Tax System. The reforms are based on the recommendations of the Review of Business Taxation, instituted by the Government to consider reform of Australias business tax system.

11.2 The Government instituted the Review of Business Taxation to consult on its plan to comprehensively reform the business income tax system, as outlined in ANTS. The Review of Business Taxations recommendations to the Government were designed to achieve a simpler, stable and durable business tax system.

11.3 The New Business Tax System is designed to provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings, as well as providing a sustainable revenue base so the Government can continue to deliver services to the community.

11.4 The New Business Tax System also seeks to provide a basis for more robust investment decisions. This is achieved by:

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using consistent and clearly articulated principles;

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improving simplicity and transparency;

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reducing the cost of compliance through principled tax laws that are easier to understand and comply with; and

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providing fairer, more equitable outcomes.

11.5 This bill is part of the legislative program implementing the New Business Tax System. Other bills have been introduced and passed already and are summarised in Table 11.1.

The objectives of measures in this bill

11.6 The objective of the thin capitalisation regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. This is to prevent multinational entities taking advantage of the differential tax treatment of debt and equity to minimise their Australian tax. The thin capitalisation regime, together with other parts of the New Business Tax System, will contribute to the fairness and equity of the tax system, by maintaining the integrity of the Australian tax base.

11.7 More specifically, the measures contained in this bill are outlined in Table 11.2.

Implementation options

11.8 The thin capitalisation measures in this bill arise directly from recommendations of the Review of Business Taxation. Those recommendations were the subject of extensive consultation. The implementation options for these measures can be found in A Platform for Consultation (APFC) and A Tax System Redesigned (ATSR). Table 11.3 shows where the measures (or the principles underlying them) are discussed in those publications.

Assessment of impacts

11.9 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered, by the Government, the Review of Business Taxation and the business sector. The Review of Business Taxation focussed on the economy as a whole in assessing the impacts of its recommendations and concluded that there would be net gains to business, government and the community generally from business tax reform.

Impact group identification

11.10 The measures in this bill specifically impact on those taxpayers identified in Table 11.5.

Analysis of costs/benefits

Compliance costs

11.11 The objective of the thin capitalisation regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. This is to prevent multinational entities taking advantage of the differential tax treatment of debt and equity in order to minimise their Australian tax. The most appropriate method of assessing whether in fact the Australian operations of a multinational entity are sufficiently capitalised is by the application of an arms length test. Such a test requires the analysis of the assets, liabilities and cash flow of the Australian operations of the entity to ascertain if the level of debt of the operation is in fact commercially justifiable for an independent entity. After significant consultation with industry representatives, it was recognised that the application of this test may be quite onerous leading to an increase in compliance costs. To reduce the compliance burden, a safe harbour approach was adopted as the rule of general application. The safe harbour allows sufficient protection of the Australian tax base to be provided whilst simultaneously minimising compliance costs.

11.12 Standard practice with new measures, requires entities affected by them to incur a cost in either familiarising themselves or having advisers familiarise themselves with the new law. The inclusion of a de minimis test ensures that the majority of entities which will fall within the thin capitalisation regime are larger more sophisticated businesses. Therefore, despite the relative complexity of this area of the law, this fact, in conjunction with the extensive consultation undertaken in relation to this measure will, to a certain extent, operate to limit that initial cost. Higher compliance costs may be incurred overall as a result of more entities being subject to the new measures. Specifically, entities with foreign investments are now subject to the thin capitalisation regime and permanent establishments are now required to prepare financial statements in accordance with accounting standards.

11.13 There will also be some additional costs for some taxpayers as they seek to restructure their financing so as to comply with the new rules from when they first apply. These may include those associated with obtaining financial advice, discharging debts and raising share capital. In this respect, transitional relief will be provided by only applying the new regime at the end of the first income year beginning after 30 June 2001. For those taxpayers that balance on a day other than 30 June this will be after 30 June 2002.

11.14 Overall, although the measures in this bill may increase compliance costs, they are part of the Governments actions taken to improve the integrity of the business tax system as it applies to multinational businesses. However, these increases will be partially offset by some measures in this bill that are expected to reduce compliance costs. It is not possible to finally quantify the compliance costs associated with these measures as the relevant data required to extrapolate such a figure is not available.

11.15 Below are some specific examples of how the measures in this bill will impact on compliance costs.

Thin capitalisation

11.16 Currently the thin capitalisation measures apply only to foreign controlled Australian operations and non-residents deriving Australian assessable income. The current measures aim to limit excessive debt borrowed from foreign related parties and debt covered by formal guarantee. The new measures will extend the thin capitalisation provisions to Australian multinational investors with controlled foreign investments and will apply to the total debt of the Australian operations of both groups of multinationals. In this regard there will be some initial and ongoing compliance cost to Australian multinational taxpayers, which will have to determine whether their debt deductions will be affected by the application of the new measures. Compared with the current arrangements, the thin capitalisation measures will involve an increase in compliance costs, while the removal of interest expenses from the general rule of denying deductions for expenses incurred in earning exempt foreign income and from the foreign loss quarantining provisions, in most cases, will decrease compliance costs. In addition, the removal of the debt creation rules, as well as the easing of the foreign control test will result in some compliance cost savings. It is not possible to identify the net effect, however, it is unlikely to be significant.

11.17 The compliance burden - particularly on smaller entities operating in Australia - has been significantly eased by the adoption of a de minimis exemption for taxpayers with total debt deductions (combined with those of certain associates) below $250,000 in a financial year. Once a taxpayer establishes that its annual debt deductions do not exceed $250,000, it is outside the thin capitalisation regime and need go no further.

11.18 Additional compliance costs may arise as a result of the arms length test, as initially it may be difficult to apply until taxpayers become more familiar with it. Specifically, application of the arms length test requires analysis of the assets, cash flow and liabilities of the Australian operations of the multinational entity. The entity is required to keep accurate records of this analysis. Recourse to the arms length test is currently available in thin capitalisation cases where a double tax agreement country is involved. Therefore, the arms length test is not an entirely new issue, however, its application may be on a wider scale.

11.19 The Review of Business Taxation considered it appropriate to have regard to accounting principles in the development of taxation legislation. The use of Australian accounting standards in determining the value of assets for the purpose of applying the safe harbour debt test will reduce compliance costs for many taxpayers as the tax values of assets will be more closely aligned with accounting principles and practice. For some taxpayers who do not need to prepare financial reports in accordance with accounting standards there may be initial compliance costs in applying the accounting standards. However, the use of accounting standards will provide a reliable, consistent and transparent method to value assets. All of which will provide greater certainty to taxpayers in applying the new measures.

11.20 It was originally anticipated that the new measures would apply to consolidated groups where an Australian group was consolidated for tax purposes. However, with the commencement of the consolidation regime being deferred until 1 July 2002, the thin capitalisation regime will put into place an interim grouping rule. This rule will allow resident entities of the same wholly-owned group to form, subject to certain conditions, a resident thin capitalisation group. The resident thin capitalisation group would determine its maximum allowable debt or minimum capitalisation as if it were a single entity using consolidated figures. If any debt deduction is to be disallowed as a result of the group calculation, it would be done on a proportional basis in the tax return of each entity within the group. There may be minor compliance costs associated with the identification of entities which are eligible for thin capitalisation grouping as well as those associated with the collection of the appropriate data from those grouped entities. It is anticipated that these costs will be substantially offset by the benefits obtained from the one off application of the thin capitalisation requirements to the grouped entity. Further, there is no compulsion to group, allowing the taxpayers to choose to group where it will be to their benefit.

11.21 The new thin capitalisation measure both raises the control threshold to determine whether an Australian investment is foreign controlled and narrows the meaning of associates. The control test is based on the CFC control tests, which in most cases require 50% control (or 40% where there is no other person with the ability to control). The definition of associates used in applying those provisions is narrowed by the inclusion of a sufficient influence test which limits associates to those entities the funding decisions of which the taxpayer has the capacity to influence. Introducing a higher threshold for control that is consistent with the CFC control test, whilst narrowing the meaning of associates, will reduce compliance costs by excluding some entities from the rules altogether that previously would have been included. Some minor changes to the CFC control tests are also being included when using them for this purpose so as to avoid unintended application of the rules.

11.22 Others that will see a change are financial entities. For non-banks, instead of an alternative debt to equity ratio, as under the existing thin capitalisation rules, some of their business (e.g. lending, leasing and securities dealing business) will be given special treatment when applying the general rule. The result of this is that they will be able to operate with higher debt levels that are tailored to their individual businesses rather than work within a one-size-fits-all debt to equity ratio. On the whole, even though the rules for financial entities are different, once they have familiarised themselves with the rules, they will be no more difficult to apply than the rules for other taxpayers.

11.23 The thin capitalisation measures applying to licensed financial entities such as banks and foreign bank branches operating in Australia will be based on the capital adequacy requirements prescribed by APRA or other regulatory bodies in their home jurisdictions. The use of information prepared for capital adequacy purposes prescribed by regulatory bodies such as APRA will result in compliance cost savings as it alleviates the need to separately prepare information for thin capitalisation purposes only.

11.24 Where Australian taxpayers borrow for investment in controlled foreign entities, they will not have to adopt special strategies to ensure the deductibility of the interest expense. This will lessen their compliance costs. In fact, many Australian taxpayers deriving foreign income will be relieved of the need to allocate interest expense between domestic and foreign income and will not have to worry about the new rules. That is because the new rules only apply in cases where a threshold level of foreign activity has been reached (e.g. operating a foreign branch or controlling a foreign entity).

11.25 The debt creation provisions, which supplement the current thin capitalisation provisions, limit interest deductions where a foreign-controlled company sells an asset to a related foreign-controlled company. The provisions disallow interest deductions where the transfer of an asset is financed using interest-bearing debt that is introduced from outside the corporate group. Because the thin capitalisation measure will apply to the total debt of the Australian operations of a foreign-controlled group the debt creation provisions are no longer needed. Removing the rules will reduce complexity and uncertainty.

Treatment of branches

11.26 Australian permanent establishments or branches of inbound investors will be required to prepare financial statements. Commencement of this requirement is being deferred for at least 12 months to allow further time to finalise details. Once introduced, taxpayers may incur ongoing compliance costs in the preparation of this information. However, the Review of Business Taxation considered that consistent with the investment neutrality principle, taxpayers that decide to carry on a business in Australia via a subsidiary or a branch should not be treated differently under the tax system. Requiring all permanent establishments to be capitalised for tax purposes in the same proportions of debt and equity will reduce these differences.

11.27 The extension of the section 128F interest withholding tax exemption to debentures issued by Australian branches of non-residents will also reduce costs. It will no longer be necessary to maintain a subsidiary operation in Australia solely for the purpose of raising these funds. Further, the treatment of these funds under the new thin capitalisation regime will be simplified.

11.28 Further details on how the measures in this bill impact on affected taxpayers can be found in the specific chapters in this explanatory memorandum explaining each measure.

Administration costs

11.29 The thin capitalisation measures are expected to produce a slight increase in administration costs as the ATO will be managing risks associated with the new measures. As more taxpayers are affected by the new thin capitalisation measures, there will be an increase in the data to be collected, and there is expected to be an increase in the requests for advice from taxpayers. However, in relation to Australian multinationals the rules will be more certain than the existing allocation rules which should reduce ATO administration costs. Nevertheless, the costs of administering the arms length tests will continue.

Government revenue

11.30 The financial impact of these measures will be a gain to the revenue as outlined in the following table:

Economic benefits

11.31 The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings. The economic benefits of these measures are explained in more detail in the publications of the Review of Business Taxation, particularly A Platform for Consultation and A Tax System Redesigned. The measures in this bill will contribute to that by improving its integrity. It will also prevent multinational taxpayers who are able to shift debt around the world from obtaining an unfair competitive advantage.

Other issues - consultation

11.32 The consultation process began with the release of ANTS in August 1998. The Government established the Review of Business Taxation in that month. Since then, the Review of Business Taxation published 4 documents about business tax reform, in particular A Platform for Consultation and A Tax System Redesigned in which it canvassed options, discussed issues and sought public input.

11.33 Throughout that period, the Review of Business Taxation held numerous public seminars and focus group meetings with key stakeholders in the tax system. It received and analysed 376 submissions from the public about reform options. Further details are contained in paragraphs 11 to 16 of the Overview of A Tax System Redesigned . In analysing options, the published documents frequently referred to, and were guided by, views expressed during the consultation process.

11.34 Exposure draft thin capitalisation legislation was released on 21 February 2001, leading to extensive consultation following submissions by interested parties.

Conclusion and recommended option

11.35 As discussed, the thin capitalisation measures have been designed to ensure that multinational entities do not shift an excessive amount of debt to their Australian operations thereby reducing their Australian tax obligations. This objective is sought to be implemented in an effective manner whilst considering the compliance impact on taxpayers. To minimise the compliance burden on taxpayers, the measures have adopted:

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a safe harbour approach;

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optional application of an arms length test;

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optional application of a worldwide gearing test in certain circumstances;

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optional grouping provisions;

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a de minimis test to exclude small business taxpayers;

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use of accounting standards to value assets and liabilities;

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modified application of the CFC control tests;

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an extension of the section 128F interest withholding tax exemption; and

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a transitional start date to accommodate taxpayers with substituted accounting periods.

The integrity of the system has been enhanced whilst balancing taxpayer concerns. Therefore, it is recommended that the measures contained in this bill should be adopted to support a more structurally sound business tax system as it applies to multinational taxpayers. They are an integral part of the New Business Tax System.