Dealing With the Changes to the Thin Capitalisation Rules. Reprinted with permissions from Business Valuation Resources, LLC

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Vol. 1, No. 1, July 2014, 3 Qtr.

BUSINESS VALUATION

AUSTRALIA

Dealing With the Changes to the

Thin Capitalisation Rules

By John-Henry Eversgerd and Joanne Dunne On 8 May this year, the federal government issued exposure draft legislation proposing changes to the thin capitalisation rules. When passed, these changes can result in higher taxes for multinationals if not managed appropriately. These changes have been well signalled, with

the previous Labor government first announc-ing proposed changes in May 2013 in the 2013/2014 budget, and, following a change of government, the current federal government confirmed in November 2013 that it would be proceeding to legislate the changes previously proposed.

In this article, we summarise the current thin capitalisation rules and the proposed changes. We then briefly touch on the impact of the changes before turning to consider a solution where adverse impacts arise. We focus on the revaluation of assets, including intangible assets, as a practical step that affected entities can take to manage the impact of the proposed changes.

The thin capitalisation rules—current rules and proposed changes. The policy intent of the

thin capitalisation rules is to prevent the alloca-tion of excessive debt deducalloca-tions to Australia, as compared to other jurisdictions.

The thin capitalisation rules apply to both inward and outward investment, that is, to entities that are either:

• Foreign-controlled Australian entities;

• Australian entities that control a foreign entity or operate from a permanent estab-lishment (such as a branch) in a foreign jurisdiction; or

• Foreign entities carrying on business in Australia.

Debt deductions are not subject to the thin capitalisation rules where they are in aggre-gate below a de minimis threshold—currently AUD$250,000, but that is proposed to increase to AUD$2 million.

The thin capitalisation rules are designed to limit available deductions on debt, where the debt levels exceed prescribed maximum debt thresh-olds. Those thresholds were designed to provide for what is considered to be appropriate gearing. A taxpayer can choose which threshold to apply each financial year. The thresholds are set out in Exhibit 1.

Some slightly different threshold tests, also set out in Exhibit 1, apply to authorised deposit-taking institutions (ADIs) such as banks and to particular financial institutions that are not themselves ADIs. These tests are broadly based on prudential regulatory requirements and are designed to ensure there is a minimum level of equity capital.

The Board of Taxation has also been tasked with a review of the debt/equity rules in Division 974 of the Income Tax Assessment Act 1997 (Cth). Amongst other matters, the debt/equity rules identify what is debt for the purposes of the thin capitalisation rules.

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As a part of the initial stages of its review of those rules, the Board of Taxation issued a dis-cussion paper in March 2014. If the Board of Taxation recommends changes in its final paper (which is due by March 2015), those propos-als may propos-also impact on the thin capitalisation rules.

The impact of the proposed changes. Affected

entities need to consider the impact of the pro-posed changes on their funding levels, tax debt deductions, and balance sheet and take advice for adjustments where necessary.

In particular:

• The reduction of the general safe harbour ratio from 3:1 to 1.5:1 means that affected entities will need to investigate the alter-natives (the worldwide gearing test and arm’s-length test) more closely.

• The changes impacting on ADIs/banks are likely to have lesser impact, as affected organisations have been compliant with Basel III since January 2013 in any event. • The changes will particularly impact

resources and infrastructure entities that generally carry a large level of debt funding. Those entities will need to con-sider their balance sheets, concon-sider asset revaluations, and may need to restructure current financing arrangements (which will, of course, itself give rise to tax issues). Foreign investors in resource and infra-structure projects will expect a particular level of return that may be affected by the impact of these changes on the balance sheet.

• The proposed changes will also potentially impact on the ability to attract new foreign investment in resource and infrastructure projects and the cost of such funding. Although having foreign-controlled inves-tors in a project could cause the project to be subject to thin capitalisation rules, having domestic ‘outbound’ investors in a project may equally trigger the debt limits

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Exhibit 1. Thresholds for Debt Levels

Tax deductions for interest based on

How the deductible debt limit is

set based on current rules Proposed change

Date pro-posed change intended to be

effective

Safe harbour debt test (nonfinancial

entities, non-ADIs)

Currently requires debt to be no more than 75% of the total value of assets as determined under Australian accounting standards or a 3:1 debt-to-equity ratio

To be amended to provide that debt can be no more than 60% of the total value of assets as determined under Australian accounting standards or a 1.5:1 debt-to-equity ratio

Income years starting on or after 1 July 2014

Safe harbour debt test for financial

entities (non-ADIs)

Currently requires a 20:1

debt-to-equity ratio To be amended to a 15:1 debt-to-equity ratio Income years starting on or after 1 July 2014

Safe harbour minimum capital test for ADIs

Currently requires a 4%

capital-to-Australian risk-weighted assets ratio To be amended to a 6% capital-to-Australian risk-weighted assets ratio—this reflects Basel III changes to Tier 1 capital

Worldwide debt test for entities other

than ADIs—broadly the maximum level of debt is the worldwide gearing ratio (debt-to-equity ratio) applied to the total value of assets, as determined under Australian accounting standards

Currently applicable only to outbound investment (i.e.,

Australian entities investing outside of Australia)

Currently requires debt gearing in Australia equal to or less than 120% of the group’s global gearing

To be extended to cover both inbound and outbound investment

To be amended to require debt gearing in Australia to be equal to or less than 100% of the group’s global gearing (for inward investing entities, this is to be considered using the consolidated financial statements that the foreign parent is already required to prepare)

Worldwide capital

test for ADIs Currently provides that an entity’s Australian operations must be capitalised to 80% of the capital ratio of the Australian entity’s worldwide group

To be amended to provide that an entity’s Australian operations must be capitalised to 100% of the capital ratio of the Australian entity’s worldwide group

Arm’s-length debt

test for non-ADIs Broadly, the maximum level of debt is a notional amount of debt capital that would have been lent by a commercial institution in respect of Australian operations, making some assumptions (for example, that guarantees or credit support must be assumed to have not been received) and having regard to specified factors (such as general industry practice for the particular industry at issue).

There are no current changes proposed. But the Board of Taxation has issued a discussion paper considering the test, and a final paper from the Board with its recommendations is due by December 2014.

• The Board of Taxation is considering a range of issues including potentially: • Whether to remove or amend the annual

testing requirement;

• Considering the factual assumptions in determining the arm’s-length debt test to ensure it is prospective as opposed to retrospective in approach;

• Whether there should be additional safe harbour ratios in the test—such as a test that applies a ratio of net interest expense to pretax earnings;

• Whether the arm’s-length debt test could be simplified where there is no related party debt;

• Whether credit support and guarantees should be taken into account; and • Whether advanced thin capitalisation

agreements could be agreed with the ATO. No current changes proposed. The Board of Taxation’s recommendations are due by December 2014.

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(so these limitations are not purely a ques-tion of the source of

funding).

• The changes will also affect highly lever-aged mergers and acquisitions, which may therefore require revaluation (subject to when the acquisition took place) and refinancing.

• The arm’s-length debt test is of assis-tance, but uncertainty is injected into the scope of that test because of the review by the Board of Taxation. That uncertainty is compounded by the review of the debt/equity rules by the Board of Taxation, which could also potentially impact on the thin capitalisation regime. Recommendations on both reviews are awaited.

Asset revaluation as a solution. The Tax Laws Amendment (2008 Measures No. 5) Act 2008

revised the thin capitalisation rules to, among other things, allow companies to include the value of intangible assets in their safe harbour debt amount even if those assets are not pres-ently recognised on the company’s sheet.1

1 The change corrected the favourable treatment previously enjoyed by companies that grow their balance sheets through acquisition versus those that

To illustrate the potential for growth in assets used in the safe harbour calculation, let’s take a look at the enormous growth of Rebel Group Ltd’s2

balance sheet when it was acquired by Super Retail Group Ltd (owner of Super Cheap Auto) pre-dominantly as a result of valuing intangible assets. As can be seen in Exhibit 2, the addition of intan-gible assets can significantly increase the size of a balance sheet. Based on management’s initial estimates, Rebel’s intangibles more than double the asset balance, with approximately $250 million allocated to brands and software versus only $158 million allocated to cash, inven-tory, plant and equipment, and other tangible and financial assets.3

grow organically because the accounting standards typically only allow recognition of intangible assets following a ‘business combination’. Allowing the recognition of internally generated intangible assets for thin cap calculations was a positive outcome for taxpayers since most companies have intangible assets (e.g., brands, intellectual property, customer contracts, and relationships) that can now be used to increase the safe harbour debt amount regardless of whether those intangible assets were developed internally or acquired.

2 Rebel Group Limited was the head company for Rebel Sports, the premier Australian sports retailer. 3 Details regarding companies’ thin capitalisation

calculations are not publicly available to use as an illustration. Since the thin capitalisation recognition criteria generally follow the accounting treatment under Australian accounting standards, it is useful to

Exhibit 2. Intangible Assets’ Impact on Rebel Group

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Relating this example to the safe harbour debt amount, intangibles that double the balance sheet would effectively double the debt thresh-old that can qualify for tax deductions. While the size and type of intangible assets differ for each company and industry, it can generally be expected that most companies have intangible assets whether or not they appear in the com-pany’s financial statements.

Some examples of the types of assets that can be included in safe harbour debt calculations are listed in Australia’s accounting standards, includ-ing those presented in Exhibit 3.

Requirements for thin capitalisation valu-ations. The tax law states that

profession-als with expertise in valuing the specific type of asset should perform all valuations for thin capitalisation purposes. This is not surprising since the analysis can be complex and support for assumptions is challenging to find. In some cases, preferred valuation methodologies have been tested over the years in courtrooms or have been reviewed by ASIC and the ATO. In many cases, the best methodology depends on the characteristics of the company or of the

look at the intangible assets recognised to meet the AASB3 Business Combination reporting requirements for the acquisition of Rebel Group Limited.

Exhibit 3. Examples of Identifiable Intangible Assets

Customer-related intangibles Technology-based intangibles Legal or contract-based intangibles

Customer lists Patented and unpatented technologies Licensing, royalty agreements

Order or production backlog Software Leasing agreements

Customer contracts Databases Broadcasting rights

Customer relationships Secret formulas, processes Permits

Distribution network Research and development Supply contracts

Broker/agent relationships Take or pay agreements

Maintenance and service contracts Artistic-related intangibles Government licenses

Fund management agreements Plays Mining permits

Business in-force Books Exploration tenements

Pictures Mineral reserves

Marketing-related intangibles Musical works Water rights

Brands Videos Port access rights

Trade marks Audio visual material Landfill space

Internet domain names Copyrights Liquor and gaming licenses

Noncompetition agreements Newspaper mastheads

particular asset. The tax law, in order to limit the risk of biased valuation outcomes, states that an independent expert is required to review any internal thin capitalisation valuations even if the company has internal experts who will perform the valuation analysis.

Conclusion. Many inbound and outbound

investors subject to Australia’s thin capitalisa-tion rules are expected to face reduced tax deductibility of interest for their Australian debt due to the proposed tightening of the law. An increased number of companies are availing themselves of the allowance to include the value of off balance sheet assets in their safe harbour debt calculations. Although the thin capitalisa-tion rules will translate into larger tax bills for those breaching the current limits or the pro-posed lower limits, planning ahead and valuing intangible assets for thin capitalisation purposes has the potential to dramatically increase safe harbour debt amounts and qualifying interest deductions.

Jo hn- H e nr y Eve r sge r d i s p a r tn e r at

McGrathNicol and can be reached at jeversgerd@

mcgrathnicol.com. Joanne Dunne is partner at

Minter Ellison and can be reached at Joanne.