Thin Capitalisation explained

When setting up a new company that is part of a group, you need to consider how the company will be funded. Setting up a company overseas creates further complications and considerations. To prevent multinational enterprises from shifting profits from Australia (or vice versa), thin capitalisation rules were introduced. The way an entity is capitalised affects reporting of profits for tax purposes.

What is thin capitalisation?

Thin capitalisation rules apply where an entity’s assets are funded by high levels of debt and little equity. The rules are designed to counter cross-border shifting of profit.

Why is thin capitalisation significant?

Most jurisdictions allow for deductions of interest paid or payable (on debt), which affects the calculation of profit. Where there is a higher level of debt, there will more interest paid and therefore less taxable profit in that country. As a result, it is understandable that debt would be the preferred method of capitalising entities in many cases.

Due to these potential benefits of debt financing, most jurisdictions have implemented thin capitalisation rules which limit the amount of interest that is considered an allowable deduction. 

How does it work in Australia?

In Australia, the rules disallow a deduction for a portion of specified expenses incurred only as a result of debt financing, which are referred to as ‘debt deductions’. The rules only apply where the specified debt-to-equity ratio have been exceeded.

What types of funding is captured?

Debt funding includes providing loans, bills of exchange, or promissory notes. Where there is interest-free debt, this amount will not be included in the calculation of the entity's debt.

When calculating debt deductions, certain expenses are specifically excluded:

• rental expenses
• certain leases
• some foreign currency losses

When do the rules apply and how is the ratio calculated?

The rules apply to both Australian and foreign entities that have multinational investments:

1. Australian entities with specified overseas investments – referred to as ‘outward investing entities’;

2. Foreign entities with certain direct or indirect investments in Australia – referred to as ‘inward investing entities’.

The thin capitalisation rules do not apply in the following circumstances:

• The entity is an Australian resident entity that is not an inward investing entity nor an outward investing entity
• The entity is a foreign entity that has no investments (such as assets) or permanent establishment in Australia
• The entity meets any of the three threshold tests:
• Debt deductions, together with those of any associate entities, are $2 million or less for the income year
• The entity is an outward investing entity that is not also foreign controlled and the entity meets the assets threshold test
• The entity is a special purpose entity established to manage certain risks

To calculate an entity's maximum allowable debt for an income year refers to the following amounts:

• the safe harbour debt amount,
• the arm’s length debt amount, and/or
• the worldwide gearing debt amount.

The thresholds for maximum allowable debt are different for outward and inward investing entities.

How can Tax Controversy Partners help you?

Thin capitalisation rules are complex area of law to navigate, and without proper advice, entities could be calculating their profit for Australian tax purposes incorrectly. We are also experienced in providing structuring and international advice that considers your unique circumstances and goals – so that you can make the right choices in your situation.

At Tax Controversy Partners, our experienced lawyers can assist you in understanding complex thin capitalisation rules and other international structuring requirements. We can assist you with implementation of entities. For advice and assistance, please contact us using our online contact form, via email at admin@taxcontroverypartners.com.au or by phone at 02 8513 3813.