The term "thinly capitalised" is used to describe a business that relies heavily on debt financing and has a relatively low proportion of equity funding to support its assets. The capitalisation method employed by an organisation will exert a substantial influence on the reported earnings for tax-related purposes.
In several countries, it is common practice to permit the deduction of interest expenses incurred for determining taxable profits. Hence, when the level of debt increases, the amount of interest paid also increases, resulting in a decrease in taxable profit. Due to this rationale, debt is considered a more favourable and tax-efficient means of financing in comparison to equity.
Why is the tax office interested in this?
Due to the possible advantages associated with debt financing, several nations have implemented regulations that establish a threshold for the deductible interest amount for determining taxable profits. The purpose of these regulations is to mitigate the practice of transferring profits across national borders by utilising an excessive amount of debt. In Australia, there exists a regulation that prohibits the allowance of a deduction for a specific fraction of costs that are spent in connection with debt financings, commonly referred to as debt deductions. The aforementioned regulations are applicable in instances where the debt-to-equity ratio is above specific thresholds.
At what point in time do the regulations become applicable?
Debt interests encompass several financial instruments, such as loans, bills of exchange, and promissory notes. Interest-free debt is not considered as a component of an entity's overall debt. There are some costs that are not eligible for debt deductions, such as rental expenses, certain leases, and certain foreign currency losses. The regulations are applicable to both domestic and international firms engaged in multinational investments, including those originating from Australia.
Australian entities that own designated foreign investments are referred to as outward investing entities.
Inward investing entities refer to foreign entities that possess specific assets in Australia, irrespective of whether they hold these investments directly or through Australian corporations.
If any of the following requirements are met, an entity will not be subject to the implications of thin capitalisation rules:
The entity in question is a resident entity based in Australia, which does not fall under the category of either an inward investing entity or an outward investing entity.
The aforementioned entity is a non-domestic entity that lacks any kind of financial investments, such as assets, or a lasting presence within the borders of Australia.
The entity satisfies any of the three threshold conditions.
The total amount of debt deductions, including those of any affiliated organisations, does not exceed $2 million for the given fiscal year.
The subject under consideration is an entity engaged in external investment activities, which is not concurrently under foreign control. Furthermore, the entity satisfies the criteria set out by the assets threshold test.
The entity in question is a specialised purpose entity that has been created with the primary objective of effectively managing certain risks.
What type of entities does thin capitalisation apply to?
The thin capitalisation regulations in Australia are applicable to the following entities:
Australian entities engaging in international investment activities, along with their associated entities. Additionally, it investigates the reciprocal occurrence of foreign businesses investing in Australia.
If an affirmative response is provided to any of the enquiries presented below, or if there exists a potential for the rules to be applicable, it is advised to peruse this book in order to ascertain whether one is subject to the thin capitalisation restrictions.
Does your company engage in international commercial activities beyond the borders of Australia?
Is there a level of control exerted over a foreign entity by ownership of at least 10% of its interests (including both direct and indirect interests, as well as interests held by associated businesses), or through other means of substantial influence over the foreign corporation?
Do you have any affiliations with individuals engaged in business activities outside of Australia or possessing a minimum 10% stake in a foreign organisation?
Does your Australian entity exhibit control by foreign entities, whether via direct or indirect means?
Are you a non-domestic entity that possesses investments in Australia?
When evaluating the potential impact of thin capitalisation regulations on your situation, it is necessary to examine:
Undercapitalised entities with limited financial resources
The functioning and implementation of regulatory guidelines
Management and oversight of one's organisational entity
Classification and categorisation of different types of entities
Merged or affiliated groups of entities and their tax obligations
Standardized benchmarks for determining acceptable debt thresholds or capital requirements
Opting to adhere to the regulatory framework for Authorised Deposit-taking Institutions (ADIs) Determining whether specialist credit card institutions should be classified as financial entities or ADIs
Applying the relevant regulations to accounting periods that span only a portion of the year.