In debt financing, an entity is considered ‘thinly capitalised’ where the assets are funded by a high level of debt and little equity. But why is this significant? The way an entity is capitalised will have a significant impact on the amount of profit is reports for tax purposes. Most countries allow for a deduction of interest paid or payable when calculation tax on profit. Therefore, the higher the level of debt, the most interest paid, the lower the taxable profit. For this reason, debt is a preferred, tax efficient method of finance than equity.
As a result of the potential benefit reached through debt financing, most countries have imposed rules which place a limit on the amount of interest that can be deducted in calculating the measure of profit for tax purposes. These rules are designed to counter cross-border shifting of profit through excessive debt. In Australia, the rules disallow a deduction for a portion of specified expenses incurred in relation to debt financings – ie. debt deductions. The rules apply once the debt-to-equity ratio exceed certain limits.
Examples of debt interests include loans, bills of exchange, or a promissory note. Interest free debt does not count as part of an entity’s debt. Certain expenses are excluded from being debt deductions including rental expenses or certain leases and some foreign currency losses. The rules apply to both Australian and foreign entities that have multinational investments:
1. Australian entities with specified overseas investments – these entities are called outward investing entities
2. Foreign entities with certain investments in Australia, regardless of whether they hold the investments directly or through Australian entities – these entities are called inward investing entities
An entity will not be affected by the thin capitalization rules if one of the following tests is satisfied:
Thin capitalization rules are complex to navigate, and our expert team can guide you through the process. Our solicitors and advisors are experienced in providing comprehensive advice to many multinational clients. If you need assistance, please contact Waterhouse Lawyers on 02 9252 8746 or firstname.lastname@example.org to discuss your entity structure.