Legal News & Analysis – Asia Pacific – Australia – Tax
WHAT YOU NEED TO KNOW
- It is currently proposed that, from 1 July 2014, Australian entities that have borrowed to invest in a nonportfolio stake in an offshore company will no longer be able to deduct the interest, regardless of their thin capitalisation position.
- There will be no grandfathering for existing arrangements.
- There will be some compliance "concessions" for tracing deductible v non-deductible interest, but use of the concessions would most likely result in a higher level of denial of deductions.
WHAT YOU NEED TO DO
If impacted:
- start assessing your options for restructuring or refinancing existing investments; and
- consider the financing and structuring of proposed investments.
In the 2013/14 budget, the Federal Government announced that it intended to repeal section 25-90 of the Income Tax Assessment Act 1997 with effect from 1 July 2014. Broadly, this provision provides deductbility for debt-related expenses, eg interest, for Australian entities earning certain nonassessable non-exempt income, including nonportfolio dividends.
Section 230-15(3), which is the Taxation of Financial Arrangements equivalent provision, will also be repealed from this date.
Treasury and the ATO have recently confirmed that the Government is, if re-elected, committed to implementing the measure in its proposed form. There will be some compliance concessions for tracing deductible v non-deductible interest, but the effect of such concessions may result in increased denial of deductions for many taxpayers. A working group has been formed to develop some practical guidance on the tracing principles, which will presumably rely on historic, and sometimes ambiguous, case law.
At the time of writing, the Coalition has not indicated its position on this proposal.
What does it mean?
Put simply, from 1 July 2014, Australian entities that have borrowed to invest in or acquire a nonportfolio stake in an offshore company will no longer be able to deduct the interest, regardless of their thin capitalisation position. There will be no grandfathering for existing arrangements.
The following examples provide an indication of the sorts of arrangements that will be impacted:
- An entity borrows funds in Australia to contribute equity to an offshore acquisition vehicle that makes a bid for an offshore business – the interest will be non-deductible in Australia.
- An entity borrows from its offshore parent to contribute equity to its offshore subsidiary – the interest will be non-deductible in Australia (but still subject to 10% withholding tax).
This change may fundamentally alter the economics of existing and proposed investments entered into or being considered prior to this announcement.
It will also cause practical problems as it will now be necessary to trace the source of funds used to make existing offshore investments and relevant documentation may not be available.
What can entities do?
Australian entities should start assessing their options for restructuring or refinancing. Options to be considered could include:
- using domestic working capital to pay down non-deductible debt;
- drawing new debt to fund domestic uses (such as paying dividends);
- debt for equity swaps and debt push downs to foreign investments; and
- "out from under" strategies for the Australian arm of foreign multinationals, ie Australia transfers foreign subsidiaries to its foreign parent – either as repayment of shareholder loans or as a return of capital.
The financing and structuring of proposed investments will also need to be revisited in light of the new regime. In some cases, the change may mean that entities may consider exiting certain offshore investments.
Caution required
We understand that the ATO has refused to rule out the possibility that Part IVA could apply to restructuring designed to secure on-going deductions. This means that entities will need to be careful in how they approach this issue.
