Submission No. 237 Back to full list of submissions
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16 April 1999


The Secretary
Review of Business Taxation
Department of Treasury
Parkes Place


Dear Sir

A Platform for Consultation Paper
Submission - Thin Capitalisation Rules for Foreign-Owned Groups with Separate Entry Structures into Australia

Arthur Andersen’s clientele includes many foreign investors with major investments in Australia. As such, since the introduction of the thin capitalisation rules in 1987, we have had substantial experience with the practical issues arising out of the application of these rules.

The purpose of this submission is to bring to your attention one of the more significant defects in the thin capitalisation rules for your consideration during the Government’s current tax reform process. The removal of this defect will increase the efficiency of the tax system without deleteriously affecting the tax base by providing scope for tax avoidance. The submission also provides comment in relation to the proposed changes to the current thin capitalisation rules.


The thin capitalisation rules were introduced with the objective of addressing the incentive which foreign controllers would have, on the basis of the different treatment of dividend and interest payments, to utilise excessive levels of debt funding in preference to equity funding in respect of "controlled" Australian companies. The rules operate to protect the Australian revenue base by denying the deductibility of interest incurred on foreign debt in excess of the specified ratio. Currently, the ratio of maximum foreign debt to foreign equity allowed is 2:1.

The above rules calculate foreign debt based on total foreign debt within each corporate sub-group, and foreign equity by reference to the Australian holding company (ie the top company in the chain) of the relevant sub-group. Foreign corporate groups with more than one sub-group in Australia are required to perform the thin capitalisation calculation for each sub-group.

It is currently not possible to amalgamate total foreign debt and total foreign equity that the foreign controller has in various Australian sub-groups to perform a single overall calculation to determine compliance with the rules. This is illustrated by the following example:

Under the current rules, HoldCo A Pty Ltd has foreign equity of $10 million. The sub-group to which HoldCo A Pty Ltd belongs (comprising HoldCo A Pty Ltd, B Pty Ltd and C Pty Ltd) has total foreign debt of $20 million. Accordingly, none of these companies may borrow further amounts from UK Parent Co without breaching the thin capitalisation rules. In contrast, the sub-group comprising HoldCo X Pty Ltd and Y Pty Ltd may borrow up to a further $12 million from UK Parent Co without breaching the thin capitalisation rules. This is because HoldCo X Pty Ltd has foreign equity of $10 million whereas total existing foreign debt within this sub-group is only $8 million.

However, should the thin capitalisation rules allow for the consolidation of all foreign equity and foreign debt for the purpose of determining compliance with the rules, total foreign equity would be $20 million. Accordingly, the maximum foreign debt allowed would be $40 million, such that any of the Australian subsidiaries may borrow a further amount up to an additional $12 million on a group basis without breaching the thin capitalisation rules.


Non-Resident Parent for Australian Group Companies

While the above operation of the provisions may not present a practical impediment to many newly organised company groups which could take into account the requirements of the thin capitalisation rules, these requirements can produce a severe impediment for groups, which for historical reasons (for example, manufacturing of entirely differentiated products within separate operational sub-groups after takeover situations) have resulted in separate holding company structures. There will of course be other groups that wish to invest in Australia but also prefer to be organised other than by way of common holding company.

We note in this regard that the requirement to measure foreign debt and foreign equity separately for each sub-group is incongruous when contrasted with various provisions of the tax legislation. For instance, the loss grouping provisions for wholly-owned company groups would apply to the above example such that losses incurred by any of the companies in the HoldCo A Pty Ltd sub-group may be transferred to any of the companies in the HoldCo X Pty Ltd sub-group to the extent there are profits in a particular company in the latter sub-group, and vice versa.

Similarly, taxation under the capital gains tax ("CGT") rules may be deferred where assets are transferred via roll-over between any of the Australian resident companies in the above example. In addition, in a broad range of anti-avoidance provisions, all entities in a wholly-owned company group are treated as belonging to the same group, regardless of sub-group organisation (for example, under the CGT provisions where assets are transferred at less than their market value).

In the above areas of the tax legislation, the fact that there are separate sub-groups is not considered to be relevant. Equally, we do not see the relevance of having different sub-groups for the purposes of applying the thin capitalisation rules.

Whilst we recognise the concerns of the Ralph committee as set out in our main submission on consolidation, we indicated therein we believe that these concerns can and should be addressed without introducing inequities in the system which will offset investment decisions.

We understand that under the Foreign Investment Review Board ("FIRB") rules which preceded the introduction of the thin capitalisation rules, the debt to equity ratio for FIRB purposes may have been independently calculated using separate sub-groups. This may have led to the thin capitalisation rules being drafted to apply to different sub-groups as well. Even if this is historically correct, in our view, it is merely a historical anachronism with no continuing policy basis.

The effect of the current operation of the thin capitalisation rules to sub-groups is merely to introduce non-neutrality in the commercial structuring of investment which, we would assume you would agree, to be undesirable unless there is an overriding reason which exists for such tax-based non-neutrality.

We therefore submit that this non-neutrality be removed by amendment of the thin capitalisation provisions. We accept that, consistent with the other instances of "grouping" as discussed above in relation to losses, CGT asset roll-overs and anti-avoidance provisions, the sub-groups should only be treated as one group for thin capitalisation purposes when they are 100% wholly-owned group entities.

This amendment is required, in our view, whether or not the proposals for consolidation of tax returns are implemented. It is equally appropriate to calculate the thin capitalisation ratio on a single group basis whether a company group prepares individual or consolidated tax returns.

In our view, legislative amendments to effect this would not be complicated, would involve no complex legislative drafting, and could be readily implemented without imposing an increased administrative burden on either taxpayers or the Australian Taxation Office. We would be pleased to prepare draft legislative amendments to illustrate how our proposed changes could be implemented.

Proposed Changes

In their present form, the thin capitalisation provisions only apply to related party debt. The proposed changes contained in the Platform for Consultation Paper of the Review of Business Taxation recommend taking into account all debt, from both related and unrelated companies (using either a worldwide group formula or a fixed ratio). Insufficient detail of the method of calculation has been provided. In any event, we are concerned about the likely consequences of implementing and applying a new regime to currently-existing group financing arrangements. This could, in effect, constitute retrospective taxation.

In this regard, we submit that the recommendations, in their present form, require considerably more clarification and explanation. Until this is provided, we are unable to comment meaningfully on the proposals.

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We would be happy to discuss our submission in further detail with either you or your officials. To that end, please do not hesitate to contact Michael Wachtel on (03) 9286 8620.

Yours faithfully