Senate

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Josh Frydenberg MP)

Chapter 2 Thin capitalisation

Outline of chapter

2.1 Schedule 2 to this Bill amends the ITAA 1997 to improve the integrity of the income tax law by modifying the thin capitalisation rules to prevent double gearing structures.

2.2 All references in this Chapter are to the ITAA 1997 unless otherwise stated.

Context of amendments

2.3 The thin capitalisation rules (Division 820) apply to foreign controlled Australian entities, Australian entities that operate internationally and foreign entities that operate in Australia. In the case of an entity that is not an ADI, the rules operate to, broadly, deny deductions for debt financing expenses if the entity's debt exceeds certain limits (and the entity is therefore thinly capitalised). These limits are determined by reference to the greater of a 'safe harbour' debt amount, a 'worldwide gearing' debt amount and an 'arm's length' debt amount.

2.4 Foreign investors are increasingly entering into 'double gearing' structures that allow them to convert more of their active business income to interest income that is subject to interest withholding tax of 10 per cent, or less in certain circumstances.

2.5 Double gearing structures involve multiple layers of flow-through holding entities (trusts or partnerships) that each issue debt against the same underlying asset. This allows investors to provide a greater proportion of their capital as investor debt and gear higher than the thin capitalisation limits allow. As a result, investors are able to maintain and deduct higher levels of debt financing expenditure.

2.6 The 'associate entity' provisions in Subdivision 820-I are intended to prevent double gearing by requiring grouping of associate entities (essentially where there is a controlling interest of 50 per cent or more) when working out each entity's debt limits under the thin capitalisation rules, including its limit under the safe harbour debt amount. Broadly, these rules look to the underlying assets of the entity and under the safe harbour debt amount, allow gearing of up to 60 per cent of those underlying assets, effectively preventing re-gearing of the same underlying assets using layers of entities (that is, cascading equity).

2.7 It is common in some sectors for consortiums to provide funding through a combination of equity and debt. These investors typically have controlling interests of 20 per cent to 40 per cent and therefore fall below the 50 per cent threshold. Consequently, these investors are able to minimise tax through double gearing.

Example 2.1 : Double gearing in relation to the safe harbour debt amount

SPV Trust 1, SPV Trust 2 and Trust are subject to the thin capitalisation rules. All monetary values reflect the values of the relevant assets, debt and equity at each measurement day in a period in accordance with Subdivision 820-G.

Trust holds $300 million of assets (that are not interests in other entities). Therefore, the safe harbour debt amount should be $180 million (60 per cent of $300 million).

SPV Trust 1 and SPV Trust 2 have direct control interests in Trust of 33.33 per cent each. This is below the 50 per cent or more threshold for Trust to constitute an associate entity for SPV Trust 1 and SPV Trust 2. Therefore, the interests held by SPV Trust 1 and SPV Trust 2 in Trust do not give rise to associate entity equity.

Consequently, the safe harbour debt amount for both SPV Trust 1 and SPV Trust 2 is $24 million (60 per cent of $40 million).

Through the insertion of the SPV Trusts, the Foreign Pension Funds are able to inject an additional $48 million of debt into the structure, and claim interest deductions for that debt (because the debt levels in SPV Trust 1, SPV Trust 2 and Trust are within their respective safe harbour debt amounts). This is despite no change in the level of the underlying assets (that are not interests in other entities).

2.8 To address this concern, the Government is improving the integrity of the income tax law by lowering the associate entity threshold under the thin capitalisation rules from 50 per cent or more to 10 per cent or more (where they apply to determine associate entity debt, associate entity equity and the associate entity excess amount) for interests in trusts and partnerships. This will prevent foreign investors from using multiple layers of flow-through entities to convert trading income into favourably taxed interest income.

Summary of new law

2.9 Schedule 2 to this Bill amends the ITAA 1997 to improve the integrity of the income tax law by modifying the thin capitalisation rules to prevent double gearing structures.

2.10 For the purposes of determining associate entity debt, associate entity equity and the associate entity excess amount under the thin capitalisation provisions, a trust (other than a public trading trust) or partnership that is an associate of the other entity referred to in the relevant provisions will be an associate entity of that other entity if the other entity holds an associate interest of 10 per cent or more in that trust or partnership.

2.11 In addition, in determining the arm's length debt amount, an entity must consider the debt to equity ratios in entities that are relevant to the considerations of an independent lender or borrower.

Comparison of key features of new law and current law

Detailed explanation of new law

2.12 Schedule 2 to this Bill amends the ITAA 1997 to improve the integrity of the income tax law by modifying the thin capitalisation rules to prevent double gearing structures.

2.13 To achieve this, the amendments modify the operation of the thin capitalisation associate entity test (section 820-905) for the purposes of determining:

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associate entity debt (section 820-910);

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associate entity equity (section 820-915); and

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the associate entity excess amount (section 820-920).

[Schedule 2, item 3, subsection 820-905(2B)]

2.14 The modifications apply if the first entity mentioned in subsection 820-905(1) or (2A) is a trust (other than a public trading trust) or a partnership. [Schedule 2, item 3, subsection 820-905(2B)]

2.15 The amendments do not affect the operation of the thin capitalisation associate entity test for corporate limited partnerships (because of section 94K of the ITAA 1936).

2.16 The effect of the modifications is to:

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lower the thin capitalisation associate entity test from 50 per cent or more to 10 per cent or more; and

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ensure that subsection 318(5) of the ITAA 1936 is disregarded - as a result, a public unit trust (other than a public trading trust) will be taken to be a trust for the purposes of applying the thin capitalisation associate entity test.

[Schedule 2, item 3, paragraphs 820-905(2B)(a) and (c)]

2.17 In addition, as an integrity measure, the other entity mentioned in subsection 820-905(1) or (2A) is taken as holding an associate interest in the first entity of 10 per cent if:

•

that other entity actually holds an associate interest in the first entity of less than 10 per cent; and

•

it is reasonable to conclude that the entity, or one of the entities, who created this circumstance did so for the principal purpose of, or for more than one principal purpose that included the purpose of, ensuring that the first entity will not be an associate entity of the other entity.

[Schedule 2, item 3, paragraph 820-905(2B)(b) and subsection 820-905(2C)]

2.18 An entity that created such a circumstance will include a participant or arranger who, either alone or together with others, implements, carries out or enters into an arrangement, or that causes another entity to implement, carry out or enter into an arrangement that results in, brings about or contributes to the circumstance.

2.19 The principal purpose of an entity is one of the main purposes of the entity having regard to all the facts and circumstances. This recognises that an entity can have a number of purposes when creating, entering into or participating in an arrangement, some or all of which are principal purposes.

2.20 Therefore, where there is a principal purpose of ensuring that the first entity will not be an associate entity of the other entity and a principal purpose of achieving a particular commercial objective, the principal purpose test would be met.

Example 2.2 : An entity that is treated as holding an associate interest of 10 per cent

Foreign Pension Fund wishes to acquire an investment in Trust 2 in Australia, alongside other investors. The investment is set up such that Foreign Pension Fund has a 100 per cent direct control interest in each of Trusts 1W, 1X, 1Y and 1Z.

Each of those trusts have a 7.5 per cent direct control interest in Trust 2 and are subject to the thin capitalisation rules.

One of the principal purposes of setting up the investment in this way is to ensure that Trust 2 will not be an associate entity of Trusts 1W, 1X, 1Y and 1Z (as they each have a direct control interest below the 10 per cent threshold).

In this situation, paragraph 820-905(2B)(b) and subsection 820-905(2C) apply so that Trust 2 is deemed to be an associate entity of Trusts 1W, 1X, 1Y and 1Z for the purposes of determining associate entity debt, associate entity equity and the associate entity excess amount.

2.21 Finally, if a trust (other than a public trading trust) is a partner in a partnership and another entity (the benefiting entity) benefits under the trust (as determined under paragraph 318(6)(a) of the ITAA 1936), then in determining whether an entity is an associate of another entity, the benefiting entity is taken to be a partner in the partnership. [Schedule 2, item 3, paragraph 820-905(2B)(d) and subsection 820-905(2D)]

Example 2.3 : Impact of the amendments on double gearing in relation to the safe harbour debt amount

Assume the facts are the same as for Example 2.1.

Subsection 820-905(2B) ensures that the direct control interests of 33.33 per cent held by each of SPV Trust 1 and SPV Trust 2 in Trust will give rise to associate entity equity.

SPV Trust 1 and SPV Trust 2 will need to reduce the average value of their assets by the average value of the associate entity equity. This means the safe harbour debt amounts for both SPV Trust 1 and SPV Trust 2 are nil.

The safe harbour debt amount for Trust remains $180 million.

2.22 In response to the changes to the thin capitalisation associate entity provisions, investors may attempt to double gear by calculating a thin capitalisation arm's length debt amount (section 820-105 for an outward investing entity that is not an ADI and section 820-215 for an inward investing entity that is not an ADI).

2.23 For the purposes of determining the arm's length debt amount, regard must be had to the factors specified in subsections 820-105(3) and 820-215(3).

2.24 To safeguard against investors attempting to double gear in this way, the amendments clarify that, for the purposes of determining the arm's length debt amount, the debt to equity ratios of any entities in which the entity has a direct or indirect interest is a factor that must also be taken into account, to the extent the interest is relevant and material to the considerations of both a prudent independent borrower and a prudent independent lender. [Schedule 2, items 1 and 2, subparagraphs 820-105(3)(g)(iv) and 820-215(3)(g)(iv)]

2.25 Under this factor, the ability of relevant investments of the entity to act as security (or asset backing) to support the entity's debt is determined taking into account the burden of any debt claims the investments already have against their underlying assets (whether held directly or indirectly through further interposed entities). This would be customary in third party lending due diligence assessments.

2.26 All of the relevant factors specified in subsections 820-105(3) and 820-215(3) must be taken into account in determining the arm's length debt amount. However, this does not mean that every single factor will have a material impact on the quantum of the arm's length debt amount. Therefore, subparagraphs 820-105(3)(g)(iv) and 820-215(3)(g)(iv) do not require an assessment of direct and indirect interests that are irrelevant or immaterial to a prudent independent borrower and lender.

2.27 The interests to be taken into account would need to be of material consideration to the borrower and lender in the context of the entity's portfolio of assets. Whether an interest is relevant in particular circumstances would depend on:

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the characteristics of the interest - that is, for example, whether the interest is a legal interest, an equitable interest, a contractual interest or an interest in possession; and

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the relative size, quality, value, significance and importance of the interest in context.

2.28 The indicators of relevance include, but are not limited to, whether:

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the interest constitutes the sole or predominate asset of the entity that secures and services the entity's debt; or

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the interest is one of many other assets of the entity but is highly valuable.

2.29 The inclusion of the new factor in paragraphs 820-105(3)(g) and 820-215(3)(g) does not affect the interpretation of the other factors that must be taken into account in determining the arm's length debt amount, but needs to be taken into account with the other factors.

Example 2.4 : Consideration of the factor in subparagraph 820-215(3)(g)(iv)

Assume the facts are the same as for Example 2.1, except that SPV Trust 1 holds a range of interests in other entities and the investment in Trust is material to SPV Trust 1.

SPV Trust 1 calculates an arm's length debt amount under section 820-215. The factual assumptions under subsection 820-215(2) are applied. All the factors under subsection 820-215(3) are taken into account, including the factor in subparagraph 820-215(3)(g)(iv).

When considering the factor in subparagraph 820-215(3)(g)(iv), it is recognised that SPV Trust 1's interest in Trust is relevant to the considerations of a prudent independent borrower and a prudent independent lender in the context of the range of interests that SPV Trust 1 holds. This is because of the characteristics, size, quality, value, significance and importance of the interest in the context of SPV Trust 1's portfolio of assets.

The impact of the debt to equity ratio of Trust is taken into account. That is, the amount of debt that SPV Trust 1 can support involves looking to the level of debt held by Trust. This is because the debt held against the underlying assets impacts the inherent value and quality of SPV Trust 1's asset base that can act as security for its own debt.

This is also considered along with all the other factors in subsection 820-215(3).

Application and transitional provisions

2.30 The amendments to prevent double gearing structures through the thin capitalisation rules apply to income years starting on or after 1 July 2018. [Schedule 2, item 4]

2.31 The amendments were announced on 27 March 2018 and will prevent taxpayers from being able to obtain unintended benefits by exploiting a loophole in the thin capitalisation rules. In this regard, the majority of income tax returns that will be first affected will be lodged in 2020 at the earliest.