Proposed changes to Australia’s thin cap rules
Aligning valuation of assets
Draft Legislation has recently been released to implement a 2018-19 Federal Budget announcement to tighten Australia’s thin capitalisation rules by:
- requiring entities to align the value of their assets for thin capitalisation purposes with the value included in their financial statements;
- removing the ability for an entity to revalue its assets specifically for thin capitalisation purposes; and
- ensuring that non-ADI foreign controlled Australian tax consolidated groups and multiple entry consolidated groups that have foreign investments or operations are treated as both outward investing and inward investing entities.
The Draft Legislation will also remove the ability for an entity to recognise the value of certain intangible assets specifically for thin capitalisation purposes. This is designed to prevent entities from using asset revaluations to generate additional debt capacity under the safe harbour debt amount where these particular assets are not recognised or valued for accounting purposes.
The changes to the way assets must be valued for these purposes was deemed necessary by the Government because there had been a significant increase in the use of asset revaluations by taxpayers in order to generate additional debt capacity under the safe harbour debt amount.
This was enabling these taxpayers to claim greater debt deductions. Concerns had also been raised about the rigour and accuracy of some of these asset revaluations, so the Draft Legislation proposes to amend the Act to require an entity to determine or calculate assets or liabilities for the purposes of the thin capitalisation rules in the same way as it would determine or calculate them in their financial statements in accordance with relevant Accounting Standards.
It is believed thin capitalisation revaluations doubled after the safe harbour gearing ratio allowed under the safe harbour debt amount was reduced from to 1.3:1 to 1.5:1 back in 2014. At that time, it was foreseen that entities with significant amounts of debt, which had borrowed up to the old safe harbour limit, would have to restructure their financing or look at using the arm's length debt method.
However, according to the Australian Taxation Office (ATO) some entities responded to the lower safe harbour gearing ratio by increasing the value of their assets by undertaking revaluations of certain assets either for thin capitalisation purposes only. This was reflected in ATO figures which revealed that thin capitalisation-only revaluations more than doubled to A$122 billion in the year following the reduction in the safe harbour gearing ratio.
These revaluations were possible because, for some assets, such as internally generated intangible assets, exceptions applied to the general rule that an entity was required to comply with the accounting standards in determining the value of its assets, liabilities and equity capital for thin capitalisation purposes. The amendments in the legislation will remove these exceptions, with the result that any revaluation or recognition of assets and liabilities must comply with accounting standards.
The changes will apply for income years commencing on or after 1 July 2019. However, valuations that were made prior to the announcement may be relied on until the beginning of an entity’s first income year commencing on or after 1 July 2019.
Valuing debt and costs which are debt deductions
The ATO has issued two draft Determinations to help entities work out their adjusted average debt for thin capitalisation purposes. In calculating adjusted average debt, an entity must, among other things, include all of its debt capital that gives rise to debt deductions.
Valuation of debt capital
The Act requires an entity to comply with the accounting standards in calculating the value of its liabilities. Draft TD 2018/D4 states that an entity’s debt capital is a category of liabilities for thin capitalisation purposes. In the ATO’s view, debt capital must be valued in its entirety in the manner required by the accounting standards, even if it comprises debt interests that are classified as financial liabilities, equity instruments or compound financial instruments under the accounting standards.
This could include loan notes, perpetual notes and mandatorily redeemable preference shares.
Costs that are debt deductions
Draft TD 2018/D5 considers the type of costs that should be taken into account when calculating an entity’s debt deductions. These costs can include "any amount directly incurred in obtaining or maintaining the financial benefits received, or to be received, by the entity under the scheme giving rise to the debt interest".
The ATO has formed a preliminary view that the provisions can apply to the following costs:
- all deductible costs of raising finance through debt capital, directly incurred in relation to the debt capital. This includes borrowing expenses that are not claimed as deductions; and
- all deductible costs directly incurred in maintaining the financial benefit received in association with the debt capital.
The ATO also believes that such costs can be incurred before or after the establishment of the debt capital.
The Draft TD includes the following non-exclusive list of costs that may qualify as debt deductions:
- tax advisory costs incurred in relation to the debt capital, which relate to activities such as agreement drafting and valuing the debt capital;
- establishment fees;
- fees for restructuring a transaction;
- regulatory filing fees;
- legal costs of preparing documentation associated with the debt capital; and
- the costs of maintaining the right to draw down funds.
The Draft Determinations, when finalised, will apply to income tax years both before and after their date of issue.
Nexia Australia, Sydney