(traditional music)
-: Thin capitalisation relates to entities
with cross-border investments
claiming debt deductions
against their Australian assessable income.
USCo operates a business through a local Australian branch
that has prepared its financial statements
for the financial year.
A summarised balance sheet shows the Australian property
and plant assets, and associated Australian liabilities.
Interest expense for the current tax year on a bank loan
was $3 million.
To determine if thin capitalisation applies,
we need to firstly establish
that this is a cross-border investment
and consider the maximum allowable debt
in accordance with the legislation.
USCo is an example of an inward investor.
This is because it is a foreign entity
with direct investments,
the Australian branch, in Australia.
The branch is the inward investor vehicle.
As it is an Australian resident entity
with a foreign controller, USCo.
Therefore, this is a cross-border investment.
We could also have an outward investor.
This is when an Australian resident entity
is either controlling a foreign resident entity,
or carrying on a business
through an overseas permanent establishment.
For example, a foreign subsidiary or an overseas branch.
We need to remember that the outward investor rules
take priority if the entity is also an inward investor,
for example, foreign-controlled.
So that is, the debt attributable
to the foreign permanent establishment
is excluded from adjusted average debt.
So that only Australian operations are subject
to the thin capitalisation rules.
So, as we have a cross-border investment,
we now need to consider if the adjusted average debt exceeds
the maximum allowable debt.
The maximum allowable debt will be the greater
of: the safe harbour debt amount,
arm's length debt amount,
or the worldwide gearing debt amount,
noting that some entities may not be eligible
to use this last method.
The second and third methods
place the onus on the taxpayer
to establish that either the debt financing is normal
or that the Australian gearing does not exceed the ratio
for the entire controlled group.
In this clip, we are only going to consider
the safe harbour debt amount.
We should also remember that the maximum allowable debt
and any exemptions will depend upon
the category of investor.
Financial institutions
and authorised deposit-taking institutions, or ADI's,
have higher maximum allowable debt
due to the nature of their business.
General investors will have different available methods
to determine their maximum allowable debt
depending upon their classification.
So for this example, the first thing we will work out is
the safe harbour debt amount.
This is based upon a debt to equity ratio
of one point five to one.
That is that debt, giving rise to Australian deductions,
should not exceed 60% of the average adjusted value
of net assets.
Firstly, we determine the average value of
the Australian assets, in this case $56 million.
For step two, we subtract associate entity debt.
This is amounts on linked to associates
relating to the Australian permanent establishment.
As these amounts will be TC tested in the associate.
In this example, we have none.
Then, we subtract non-debt liabilities
due to Australian assets,
such as leave provisions and trade creditors.
In this case, we subtract
the $1 million leave provision.
This gives us the net Australian assets
that are funded by debt and equity.
And finally, for step four, we multiply by 60%
to arrive at the safe harbour debt amount.
We then need to consider the adjusted average debt for USCo,
which is only the bank loan.
So the adjusted average debt is $40 million.
This debt exceeds the safe harbour debt amount
of $33 million, and therefore,
the interest deductions must be scaled back
from $3 million.
The balance of interest deductions exceeding
the $2.475 million is disallowed.
There are exceptions, however,
that we need to also consider.
Thin capitalisation rules do not apply
to annual debt deductions
including associates not exceeding $2 million.
Outward investor, non-foreign controlled,
with 90% or more of assets located in Australia.
That is, Australian entities
with substantially all investments,
including their associates located in Australia.
And entities without cross-border investments.
To recap, thin capitalisation captures
cross-border investments and applies
to inward and outward investors,
where the taxpayer claims interest deductions
against assessable income in Australia.
The rules set out a maximum allowable debt
which considers total worldwide debt
financing their Australian operations.
If the adjusted average debt exceeds
the maximum allowable debt,
then debt deductions, such as interest and financing charges
will be proportionately reduced.