Australia Moves to Tighten Thin Capitalization Rules

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By Peter Hill

Rules preventing multinational companies from shifting profits offshore through the use of excessive levels of tax deductible debt are to be tightened, under Australian draft legislation.

The legislation, released for public consultation Aug. 1 by Australian Federal Treasurer Scott Morrison, would tighten thin capitalization rules by introducing two specific measures refining how the rules deny interest deductions if a company is too thinly capitalized by an offshore parent company.

The measure was announced by Morrison in May as part of the 2018-19 Federal Budget.

Under the legislation, companies would be required to align the value of their assets for thin capitalization purposes with the value included in their financial statements. In addition, companies would no longer be able to revalue assets specifically for thin capitalization purposes.

Thin capitalization refers to a situation in which a company is financed through a relatively high level of debt compared to equity, which affects the amount of profits it reports for tax purposes, according to the Organization for Economic Cooperation and Development. Country tax rules typically allow a deduction for interest paid on debt.The higher the level of debt in a company, and the amount of interest it pays, the lower will be its taxable profit, according to the OECD

Why the Change?

In explaining the new asset value rule, the government has noted that the current thin capitalization rules allow an entity to recognize certain assets and revalue its assets “in a different way in certain circumstances” than the general requirement to comply with accounting standards.

According to the government, there has recently 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.” Such revaluations allow these taxpayers “to claim greater debt deductions,” and the government has raised a concern about “the rigour and accuracy of some of these asset revaluations.”

The new asset value rule would apply to income years commencing on or after July 1, 2019. From then, all companies—and all other entities covered by the thin capitalization rules—must rely on the asset values contained in their financial statements for thin capitalization purposes.

As a transitional measure, valuations made prior to May 8, when the measure was announced, may be relied upon until the beginning of a company’s first income year commencing on or after July 1, 2019.

According to the government “the change will ensure that asset valuations used to justify debt deductions are robust.”

Foreign-Controlled Entities

Another measure announced in the 2018-19 Federal Budget and included in the exposure draft legislation would “ensure that foreign controlled Australian consolidated entities and multiple entry consolidated groups that control a foreign entity are treated as both outward and inward investment vehicles for thin capitalisation purposes.”

This change will also apply for income years commencing on or after July 1, 2019, and will, according to the government, “ensure that inbound investors cannot access tests that were only intended for outward investors.”

Combined, the two new thin capitalization measures are estimated by the government to increase revenue by A$240 million ($177.8 million) over the next four years.

The government will accept submissions on the exposure draft legislation through Aug. 17.

To contact the reporter responsible on this story: Peter Hill in Sydney at correspondents@bloomberglaw.com

To contact the editor responsible for this story: Penny Sukhraj at psukhraj@bloombergtax.com

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