International tax

Tax agenda 2013

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Proposed measures targeting profit shifting through loading of Australian debt

The Government announced in the May 2013 Federal Budget that it would tighten and improve the integrity of Australia’s international tax arrangements to address profit shifting by multinationals through the disproportionate allocation of debt to Australia.

Specifically, the Government intends:

  • Tightening and improving the effectiveness of the thin capitalisation rules including changing all safe harbour limits (for general entities the permissible debt to equity ratio will be reduced from 3 to1 to 1.5 to 1, or 60% of net Australian assets), extending the worldwide gearing test to inbound investors but reducing the ratio from 120% to 100% and increasing the de minimis threshold from $250,000 to $2 million of debt deductions (thin capitalisation measure)
  • Reforming the foreign non-portfolio dividend exemption so that in-substance debt interests do not obtain the exemption (section 23AJ measure)
  • Repealing the rules that allow a deduction for interest expenses incurred in earning exempt foreign income (section 25-90 repeal measure)

The Government’s justification for these ‘integrity’ measures is that they help secure a fair, competitive and sustainable tax base for future national prosperity. Although it is perhaps difficult to argue against a tax system that has such features, the impact of the measures (particularly the section 25-90 repeal measure) extends far beyond the integrity concerns that they seek to address.

Integrity concerns associated with excessive debt loading should be addressed through the section 23AJ measure and appropriate thin capitalisation measures. The section 25-90 repeal measure will significantly impact the competitiveness of Australian businesses by increasing the cost of capital and potentially increasing compliance costs. In addition to this, the announcement has further increased the perception of sovereign risk, thus further eroding the attractiveness of Australia as an investment destination.

Although it is suggested that the origin of the section 25-90 rule, permitting interest deductions against foreign exempt income, was as a compliance saving measure (i.e. it was not necessary to undertake time and resources in tracing borrowed funds to assessable income earning activities), its existence can be justified for other reasons.

As a matter of international tax policy, Australia has adopted an exemption system for avoiding international double tax on foreign non-portfolio dividends rather than a credit or deduction system. In most situations it is not correct to regard section 23AJ as a true exemption from tax. Secondly, the appropriate level of deductible debt should be the preserve of the thin capitalisation rules (especially since they now apply to all debt and are being amended as outlined above) rather than through the repeal of section 25-90.

If the section 25-90 repeal measure proceeds it will overturn a 12 year practice of not having to consider the tracing of borrowed funds. Post any repeal, a specific mechanism for the allocation of debt deductions will be required. In either case, the outcome for affected taxpayers is potentially worse than a return to the pre-section 25-90 days. The position is further complicated in the case of an acquisition of an Australian parent of a multinational group by a tax consolidated group. For these reasons, the Government will need to introduce appropriate transitional arrangements to ensure that businesses with locked in funding arrangements do not suffer financially.

Although we believe that existing debt arrangements should be grandfathered, if this does not occur, companies must be given time to reorganise their financial affairs without the risk that Part IVA will be applied to that reorganisation.

To overcome uncertainty associated with the correct principles for tracing funds to deductible and non-deductible debt, detailed and appropriate legislative rules must be developed through extensive consultation with all stakeholders.

It is essential that affected Australian businesses be aware of the section 25-90 repeal measure and its potential impact on current borrowings. EY is part of an ATO working Group that is considering the application of the law after the repeal.