An illustration of how the Australian thin-capitalization provision will apply to disallow a deduction by a general inward investor entity, drawn from a worked example published by the ATO (March 2016), is presented below.
The inward investor (For Co) has the following three types of investments in Australia:
- a permanent establishment in Australian (Aust PE) through which it carries on a manufacturing business;
- shareholdings in several Australian public companies (amounting to 1% of the ordinary shares in each company); and
- a block of flats which it rents out to private tenants (each block with an average value of AUD 25 million).
For Co has AUD 100 million of debt capital, of which it used AUD 20 million to fund the acquisition of the block of flats and AUD 12 million is attributable to Aust PE (because it actually raised this debt in Australia through the PE). The remaining debt capital is used in For Co's foreign business. The shares in the Australian public companies were funded by For Co's profits. Aust PE has AUD 5 million of non-debt liabilities and together with the block of flats has generated AUD 2.1 million of debt deductions in Australia. All loans are at commercial interest rates.
Aust PE's assets and liabilities for the test year based on the average values using the opening and closing balances method are as follows:
|Assets||AUD million||Liabilities||AUD million|
|Current assets||4||Debt capital||5|
|Building and plant||13||Non-debt liabilities||12|
Because For Co has debt deductions of AUD 2.1 million, it cannot rely on the de minimis rule (i.e. for a debt not exceeding AUD 2 million). Furthermore, because it is an inward investing entity, it cannot use the foreign assets threshold exclusion contained in the thin capitalization provisions.
Calculating For Co’s adjusted average debt
This is the average value of all of For Co's debt capital that gives rise to debt deductions. This is AUD 32m (i.e. AUD 12m, which is attributable to its Australian PE and the AUD 20m funding the Australian block of flats). The debt capital used by For Co on its foreign business does not give rise to deductible expenses in Australia. Furthermore, there is no associate entity debt for For Co attributable to its Australian PE, the average value of which may be used to reduce the AUD 32m. Nor may the AUD 32m be adjusted upwards to include For Co’s average cost-free debt capital since For Co has no such debt capital.
The adjusted average debt (AUD 32m) is now compared to the maximum debt allowed to For Co. The maximum allowable debt is the greater of For Co’s safe harbor debt amount, its arm’s length debt amount and its worldwide gearing debt amount.
Calculating the safe harbor debt amount
This is determined first by accounting for the average value of For Co's Australian assets (i.e. AUD 42m - representing Aust PE's assets of AUD 17m and the block of flats worth AUD 25m). This value is unaffected by various reductions that ought to be made from it, representing respectively the average excluded equity interests in For Co, the average associate entity debt of For Co, and the average associate entity equity attributable to For Co’s Australian PE, since For Co has none of these. However, for another type of reduction required (i.e. the average value of For Co’s non-debt liabilities arising because of its Australian investments), there is an amount of AUD 5m which, when subtracted from AUD 42m, brings the result to AUD 37m. This amount should then be multiplied by 3/5, to which must be added For Co’s average associate entity excess amount. Since For Co has no such average associate entity excess amount, the result is AUD 22.2m, which should be taken as its safe harbor debt amount.
Calculating the arm's length debt amount
This amount may not exceed the safe harbour debt amount. Alternatively, For Co can choose to use the safe harbour debt amount without calculating the arm’s length amount, an option it chooses to exercise in this case.
Calculating the worldwide gearing debt amount
The test may not be used unless the following formula is greater than 0.5: Average Australian assets of the entity / Statement worldwide assets of the entity for the income year. For Co’s average Australian assets for the year are AUD 17m and statement worldwide assets is AUD 140m, resulting in 0.12 based on the above formula. Therefore For Co is eligible to apply the worldwide gearing debt test.
The worldwide gearing debt amount is determined by determining For Co's gearing ratio, which is calculated based on its worldwide debt and equity. To determine the ratio, worldwide debt is first divided by worldwide equity (AUD 100m worldwide debt / AUD 40m worldwide equity = 2.5). This ratio (2.5) is then divided by the ratio plus 1 (2.5 / 3.5 = .7148587). This gearing ratio is then multiplied by For Co's net assets (.7148587 x AUD 37m), resulting in a worldwide gearing debt amount of AUD 26.44m. This would also take into account the average value of For Co's associate entity excess amount, which is AUD 0 as there are no associated entities in this example.
Calculating For Co’s debt deductions that will be disallowed
It is evident from the above calculations that For Co’s maximum allowable debt is AUD 26.44m. Because For Co’s adjusted average debt (i.e. AUD 32m) is higher than its maximum allowable debt, a portion of its debt deductions will be disallowed. The task now is to calculate the exact amount that will be disallowed.
The formula used for this purpose is: debt deduction x (excess debt ÷ average debt)
- the debt deduction is AUD 2.1m;
- the excess debt is AUD 5.56m (i.e. AUD 32m - AUD 26.44m); and
- the average debt is AUD 32m.
Thus, For Co’s disallowed debt deductions will be calculated as follows:
AUD 2.1m x (AUD 5.56m ÷ AUD 32m)
= AUD 2.1m x 0.17375 = AUD 364,875.
Therefore, the exact amount that will be disallowed as a deduction by For Co as a result of the thin capitalization provisions is AUD 364,875.