If the thin-capitalization limitations have been breached and cannot otherwise be justified, the financing costs in respect of the debt (or “debt deductions”) are denied to the extent to which they exceed the permissible ratio. Nor may the disallowed expenses be carried forward to be offset against income in future years.
What constitutes expenses for this purpose generally covers the costs incurred in connection with the debt. This would normally be the interest on a loan but would also include any other amount payable that is based on the time value of money. It also includes:
- The difference between, on the one hand, the financial benefits the entity has received or will receive under the scheme that gives rise to the debt interest and, on the other hand, the financial benefits that are provided or will be provided under that scheme, with the exclusion of foreign exchange losses;
- Any amount that the entity incurs directly in obtaining or maintaining the financial benefits it receives or will receive under the scheme;
- Certain other costs, as per the tax determination (TD 2019/12), that are directly incurred in obtaining or maintaining financial benefits received, or to be received, by an entity such as:
- Costs related to tax advisory services giving rise to or in connection with the debt capital, including but not limited to, drafting of agreements, and valuing for and/or pricing of the debt capital; etc.
- Establishment fees;
- Fees for restructuring a transaction;
- Stamp duties;
- Regulatory filing fees;
- Legal costs of preparing documentation associated with the debt capital;
- Costs to maintain the right to draw down funds; and
- Any costs considered to be borrowing expenses.
It is clarified in the TD that such costs can either be incurred prior to or pursuant to the establishment of the debt capital, provided that the costs relate to obtaining or maintaining the financial benefits received or to be received by the entity, in connection with the scheme giving rise to the debt interest. This is applicable for all income years prior and subsequent to 17 July 2019, but not be applicable to disputes settled before the said date.
Expenses relating to items such as rental payments on certain leases, as well as certain foreign currency losses, are excluded.
In case a non-authorised deposit institution (‘non-ADI’) entity’s debt capital results in debt deductions in any income year, then the entity shall include the average value of the debt capital, in its adjusted average debt, in accordance with the method statements for calculating adjusted average debt. This shall be effective for all years of income prior and subsequent to 17 July 2019 but will not be applicable to disputes settled before the said date.
No disallowance is required under the thin-capitalization rules if the entity's adjusted average debt is zero or a negative amount. If the average debt is positive, the following parameters are calculated and compared:
- Safe harbour debt amount;
- Arm’s length debt amount; and
- Worldwide gearing debt amount.
The highest among the above is the maximum allowable debt amount.
The ATO has issued Taxation Determination (TD 2020/2) that sets out how an entity must value its 'debt capital' and includes the following:
- An entity is required to comply with the accounting standards in calculating the value of its liabilities (including its debt capital);
- The debt capital of an entity at a particular time is defined to mean any debt interests issued by the entity that are still on issue at that time;
- An entity's debt capital must be valued in its entirety in the manner required by the accounting standards regardless of whether it comprises debt interests that are classified as financial liabilities, equity instruments or compound financial instruments under the accounting standards; and
- Transfer pricing rules may also be applied (see Sec. 13.2.8).
As per the TD, if the Commissioner considers that an entity has undervalued its debt capital in relation to a calculation, then the Commissioner may, having regard to the accounting standards, substitute a value that is considered by him as appropriate. The TD applies both before and after its date of issue, i.e., 25 March 2020, but will not be applicable to disputes settled before the said date.
The ATO has issued Taxation Ruling (TR 2020/4) and Practical Compliance Guideline (PCG 2020/7) regarding the arm’s length debt test and compliance approach for debt test for thin-capitalization purposes.
The arm's length debt test is available to establish an entity’s maximum allowable debt amount for thin-capitalization purposes. It focuses on identifying a notional amount of debt the Australian business would reasonably be expected to have, and what independent commercial lenders would reasonably be expected to lend. The TR and PCG have to be read collectively for applying the arm’s length debt test.
The TR applies to years of income commencing both before and after its date of issue, although it will not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue. The PCG applies to income years commencing on or after 1 January 2019 and will apply where the arm's length debt test has been used to establish an entity's maximum allowable debt from this date.
In response to the COVID-19 pandemic, the ATO had announced various measures to support affected businesses. In line with these measures, the ATO has updated the guidance on thin-capitalization so as to include a simplified approach to the arm’s length debt test (‘ALDT’).
For the tax years including the months of February and March 2020 period, a non-ADI taxpayer, who is no longer be able to rely on the safe harbour or worldwide gearing tests to determine the maximum allowable debt as a result of affected balance sheet due to COVID-19, may calculate the average values for thin-capitalization amounts by selecting the alternative valuation measurement periods that allow a degree of smoothing of values in situations where wide variations have occurred throughout the income year.
Further, the taxpayer may use all the alternative measurement periods in testing the suitability of the safe harbour or worldwide gearing tests. However, the ATO may not use compliance resources for reviewing the application of ALDT if the following requirements are met:
- The taxpayer would have satisfied the safe-harbour test but for the COVID-19 related balance sheet effects;
- The taxpayer uses best endeavours to apply all criteria of the ALDT;
- For inward investing entities (and not also outward investing entities) the compliance approach applies only to the extent that no additional related party funding is received, other than short-term (less than 12 months) debt facilities; or
- No use of ALDT by inward investing entities, as dividends paid may weaken the Australian balance sheet.