RSM Australia

Corporate interest deductions to be reduced?

Issue: News leaks that the Government will further reduce interest deductions for multinational groups.

Action: Prepare for the worst, but perhaps with a reduced company tax rate to soften the blow?

With the stage now set for an early (July 2016) Australian Federal election, leaks about the Government’s forthcoming Budget have accelerated – the latest providing mixed news for corporates, particularly international investors into Australia.

The Government has been trying to find a way to cut the company tax rate from the current uncompetitive 30%.  Attempts to date to fund a cut through ‘tax mix switch (shifting the tax burden to individuals) have failed, on the grounds of political reality.

The news leak today is a classic ‘base broadening’ stratagem – reduce the permitted ‘thin capitalisation’ ratio from its current 1.5:1(60% / 40%) down to 1:1 (50% / 50%) thus reducing tax deductions for some highly geared corporate groups. 

This ‘news’ is insider reporting, so there are no details, and more questions than answers.  But even moderately leveraged groups may face an interest expense disallowance, as a trade-off for delivering a cut to the headline company tax rate.

On the other hand, companies will benefit from a reduction in the company tax rate, and that needs to be factored in to Australian investment calculations. Winners and losers from the changes will be distinguished by the level of debt in their structures.

Date of effect

There is no word on the possible timing of these changes. We would imagine there would be no change until the 2017-18 fiscal year (1 July 2017), allowing some time to plan for and implement balance sheet restructuring, but consistent with the status of a ‘leak’, there are no details.

Australia’s ‘thin cap’ rules

Australia has had a ‘thin cap’ regime since 1987, although it was completely rewritten and ‘internationalised’ in 2001.  The rules have operated to deny ‘excess’ interest expense deductions, with various limits:

  • A ‘safe harbour’ debt amount;
  • An arm’s length debt amount; and
  • A worldwide gearing level.

The ‘safe harbour’ ratio was originally 3:1 (on a debt equity basis), but was reduced to 1.5:1 for the 2014-2015 income year.  (These ratios translate to 75% / 25% and 60% / 40% on a debt to total assets basis). 

If the news leak is correct, the ‘safe harbour’ rate will be reduced further to 1:1 (debt to equity basis) or 50% / 50% (debt to total assets basis).

Australian experience

When the safe harbour ratio was set at 3:1 our experience was that most taxpayers relied upon that approach, which was ‘compliance light’ and generally appropriate for their global gearing level and other corporate purposes.  (Construction and infrastructure companies less so.)

But with the reduction from 3:1 to 1.5:1 more taxpayers have been relying upon the (more compliance heavy) arm’s length debt test.  This has been the case particularly for those businesses with ‘locked in’ finance arrangements which cannot quickly (or cheaply) change their gearing levels. 

If the safe harbour ratio drops to 1:1, we expect the trend of using the arm’s length debt test will accelerate, thus undermining the Government’s revenue savings calculations. 

Government backflip

If this leak is correct, it reflects a significant backflip for this centre/conservative Government. In October 2015, in response to the release of the G20/OECD BEPS Final Reports, the Government stated it was comfortable with its current ‘thin cap’ settings, and would not adopt the Action 4 recommendation to introduce a ‘fixed ratio’ cap of somewhere between 10% and 30% of a company’s EBITDA, nor would it adopt the alternative 'group ratio' recommendation.

The rejection of the OECD recommendation was explained by Australia’s status as a net capital importer, and the need to respect the long term financing requirements of large scale infrastructure and production projects.  It also distanced the Government from the position of the Australian Labor Party (ALP) opposition. Seven months later, it would appear the world view has changed.

ALP position on ‘thin cap’

It is the policy position of the ALP opposition that, for multinational groups, interest deductions will be:

  • Calculated solely by reference to a worldwide gearing ratio;
  • The ‘safe harbour’ option will be repealed; and
  • The arm’s length debt approach will also be repealed.

(The ALP position appears not to adopt the BEPS Action 4 recommendations in full.  The ALP policy approach would address ‘debt dumping’ in Australia, but would appear not to cap Australian interest deductions in the case of highly leveraged global groups.) 

Whither the arm’s length debt test?

Whilst the ALP policy position on the arm's length debt test is clear, the same question can be asked of the Government ‘position’ – if the safe harbour ratio is reduced to 1:1, will the arm’s length debt test be retained?

The answer should be ‘yes’ in the interests of maintaining Australia’s credentials as a safe investment destination.

But it could be that the arm’s length debt test is repealed, or perhaps retained as a transitional measure, available only for projects of certain size, or gearing limit, with all new projects after a change date being denied access to the alternative.  We wait to see the accuracy of the leak, and the detail to follow. 

Australian political status

An Australian Federal election was due, in the ordinary course, by the end of 2016.  But the Government has re-presented core legislative amendments which were, yesterday 18 April 2016, again rejected by the Senate (upper house of Australia's Federal Parliament) giving the Government a ‘trigger’ to dissolve both Houses of Parliament, and to call a double dissolution election. 

It remains to be seen whether this occurs, but based on the Prime Minister’s language over the last month, it will be very difficult for him to avoid this outcome. The speculated timetable would be:

  • Tuesday 3 May 2016: Federal Budget
  • Thursday 5 May 2016: Opposition response to Budget
  • By Wednesday 11 May: Election called
  • Saturday 2 July 2016: Federal Election

Action

This Tax Insight is based on media speculation and alleged Government ‘leaks’.  The ‘real’ position should become clear within two weeks, at the time of the Federal Budget announcement. 

However, for those businesses planning new investments in Australia, the project economics will be affected by available tax deductions for interest expenses, including the details of any debt arrangements under consideration or negotiation, and this ‘news’ should be factored in.

For existing finance arrangements, consideration may need to be given to switching from the ‘safe harbour debt test’ to the ‘arm’s length debt test’ (assuming it survives) in order to retain tax deductibility for as much as possible of existing interest expenses. 

If you would like to discuss any of the issues raised in this Tax Insight, please contact your regular RSM Tax adviser.

RSM in Sydney - providing accountanting, auditors and consultants for sydney Businesses