Peter Costello

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Release of Exposure Draft Legislation - Thin Capitalisation and the Debt/Equity Borderline

NO.006

Release of Exposure Draft Legislation - Thin Capitalisation and the Debt/Equity Borderline

Today the Government is releasing an exposure draft of legislation that reforms the thin capitalisation rules to ensure foreign and Australian multinationals pay a fair share of tax in Australia.

The exposure draft legislation also introduces tests that make the borderline between debt and equity more certain.

Thin Capitalisation

Thin capitalisation rules aim to prevent multinational taxpayers allocating a disproportionate amount of debt to their Australian operations because of a more favourable tax treatment of debt compared to equity. The rules do this by disallowing deductions relating to excessive debt financing.

Current thin capitalisation rules are incomplete in that they cover only related party loans and foreign multinational investors.

In line with the recommendation of the Ralph Review of Business Taxation, Australia’s thin capitalisation rules are to be extended by applying them to total debt and to Australian multinationals. For banks, the rules are based on capital levels reported for regulatory purposes.

The measures will apply from 1 July 2001, but in the first year of operation entities will have the choice of measuring assets, debts and other relevant amounts at the end of the taxpayer’s accounting year.

Debt for thin capitalisation purposes is aligned with the reformed debt definition in the exposure draft legislation released today.

In addition, the Income Tax Assessment Act 1936 will be amended to exempt from interest withholding tax debentures issued by non-resident companies operating in Australia through permanent establishments. The exemption will apply to interest on debentures issued after 30 June 2001 and will also reduce compliance costs.

The Debt Equity Borderline

The Government has decided to implement the general approach recommended by the Ralph Review of Business Taxation for determining whether an interest is debt or equity.

An interest will be debt, rather than equity, if there is a non-contingent obligation to return the original investment. For interests whose terms exceed 10 years, the return of the original investment will be measured in present value terms. In general, returns on interests classified as debt are deductible and non-frankable.

In contrast, equity interests are generally characterised by returns that are contingent on the economic performance of the issuer. The returns on equity interests are generally frankable and non-deductible.

The exposure draft legislation will reduce uncertainty by providing a mechanism for classifying debt-equity hybrids as either debt or equity. It is anticipated that most converting notes (prior to conversion) will be classified as debt, while most converting preference shares will be classified as equity. Income securities, which are essentially non-cumulative, profit-contingent, perpetual instruments, will be classified as equity.

This new test provides a consistent and coherent basis for distinguishing between debt and equity for the purpose of determining whether returns are frankable or not.

Subject to transitional arrangements referred to below, the new test is to apply to returns on financing instruments made after 30 June 2001.

ATO Taxation Rulings on Income Securities

The Australian Taxation Office (ATO) has today released two draft taxation rulings on income securities. These rulings clarify the treatment of certain income securities under the current taxation law. As a result of the draft rulings, the deductibility status of certain income securities is to be retained until the new debt/equity test becomes operative, having regard to the transitional arrangements outlined below.

Transitional Arrangements for Income Securities and Equivalent Instruments

The Government has decided to provide a transitional rule, under which issuers of income securities and equivalent instruments issued prior to this announcement can elect to have the current law apply to returns paid before 1 July 2004. Issuers are required to make this election before 1 July 2001.

If an issuer makes an election, returns on these securities will not be frankable until 1 July 2004. Deductibility will be determined under the current income tax law, taking into account the date of effect of the ATO’s draft rulings. These securities will be subject to the new thin capitalisation rules from 1 July 2001.

If an issuer does not make an election, returns on income securities and equivalent instruments made on or after 1 July 2001 will be non-deductible and frankable in accordance with the new definition set out above.

Submissions

The exposure drafts and accompanying explanatory statement can be obtained from the Treasury internet site (www.treasury.gov.au) under ‘What’s New’.

Comments on thin capitalisation can be sent to:

Assistant Commissioner
International Tax Division - Business Tax Reform (Thin Capitalisation)
Australian Taxation Office
PO BOX 900
CIVIC SQUARE ACT 2608

or emailed to

thin.capitalisation@ato.gov.au

Comments on the debt/equity borderline can be sent to:

Assistant Commissioner
Law Design and Development - Taxation of Financial Arrangements
(Debt Equity Borderline)
Australian Taxation Office
PO BOX 900
CIVIC SQUARE ACT 2608

or emailed to:

debt-equity@ato.gov.au

Submissions on the exposure drafts should be received by 20 March 2001.

Submissions will be treated as public unless the author indicates to the contrary. Submissions lodged electronically will be published on the Treasury website, unless it is indicated that they are to be treated as confidential.

CANBERRA

21 February 2001

Contacts: Thin capitalisation Contacts: Debt/equity borderline
George Montanez (ATO)
02 6216 1582
Simon Matthews (ATO)
02 6216 1261
Ashley King (ATO)
03 92851409
Richard Wood (Treasury)
02 6263 4406
John Nagle (Treasury)
02 6263 4461

21 Feb 2001

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