Executive summary

On 1 August 2018, the Australian Treasury released an exposure draft law (ED) on the two thin capitalization measures announced in the 2018/19 Federal Budget. These measures are intended to further tighten Australia's thin capitalization debt deduction denial rules.

In addition, the Australian Taxation Office (ATO) released two draft tax determinations (TDs) on thin capitalization valuation of debt capital and debt classification issues.

This Alert outlines the Treasury ED and the ATO's TDs.

Detailed discussion

Thin capitalization asset valuation and inbound-outbound integrity measures draft law

The Australian Treasury has released exposure draft law (ED) on the thin capitalization changes announced in 2018-19 Federal Budget, to apply from 1 July 2019:

• Under the asset valuation measures, it is proposed that entities will no longer be able to revalue assets specifically for the purposes of the thin capitalization rules. An entity must use the value of the assets and liabilities as stated in the entity's financial statements.
  • A transitional rule applies so an entity can rely on revaluations of assets supported by the entity's most recent valuation made prior to the budget announcement (i.e., 8 May 2018), for income years commencing before 1 July 2019. The ED states that pre-budget valuations need not be updated.
• It is also proposed that non-Authorized Deposit-taking Institutions foreign controlled Australian tax consolidated groups and multiple entry consolidated groups that have foreign investments or operations will be treated as both outward-investing and inward-investing entities. This will ensure that inbound investors cannot access tests (such as the worldwide-gearing test for outward investors) that were only intended for outward investors.

Treasury is seeking comments on the ED by 17 August 2018.

The asset valuation measures may adversely impact entities that hold assets which have an accounting value that is significantly less than market value (e.g., internally generated intangible assets), and also where there is reluctance to revalue assets on their accounting balance sheet. The changes will impact many sectors including services groups, infrastructure and resources.

ATO draft tax determinations

The ATO also released two draft TDs on thin capitalization valuation of debt capital and debt classification issues:

• TD 2018/D4 – "Thin capitalisation – valuation of debt capital for the purposes of Division 820" requires that debt capital that comprises debt interests classified as financial liabilities, equity instruments or compound financial instruments must be valued in its entirety as required by the accounting standards. The draft TD closes an option that might have been used by taxpayers to only include that part of the debt interest that is classified as a financial liability for accounting purposes as the value of their debt capital.
• TD 2018/D5 – "What types of costs are debt deductions within scope of 820-40(1)(a)(iii)?" sets out the ATO's views on the type of costs that are debt deductions for the purpose of determining debt capital for thin capitalization calculations – including costs of raising financing or maintaining the financial benefits such as valuation fees, establishment fees, stamp duties, legal costs, tax advisory costs, etc. related to the debt interest issued. This will likely increase the extent of items included in "adjusted average debt."

Submissions on the draft TDs are due by 31 August 2018.

These latest changes reflect on-going scrutiny of the thin capitalization rules by the ATO, and follow a number of significant ATO audit processes and disputes and several ATO Tax Alerts.

Implications

The ED changes and draft TDs require careful analysis. It is important to note that where safe harbor calculations are adversely impacted, the thin capitalization arm's-length debt test remains available and may be a potential option for some.

———————————————
CONTACTS

For additional information with respect to this Alert, please contact the following:

Ernst & Young (Australia), Sydney

• Sean Monahan
  sean.monahan@au.ey.com
• Tony Cooper
  tony.cooper@au.ey.com

Ernst & Young (Australia), Melbourne

• Peter Janetzki
  peter.janetzki@au.ey.com

Ernst & Young (Australia), Perth

• Mathew Chamberlain
  mathew.chamberlain@au.ey.com
• Andrew Nelson
  andrew.nelson@au.ey.com

Ernst & Young (Australia), Brisbane

• Michael Hennessey
  michael.hennessey@au.ey.com

Ernst & Young LLP, Australian Tax Desk, New York

• David Burns
  david.burns1@ey.com

———————————————
ATTACHMENT

PDF version of this Tax Alert