On October 1 2001, the Australian parliament enacted in-substance rules for distinguishing between debt and equity instruments for tax purposes as well as a revised, wide sweeping thin capitalization regime. These measures represent key aspects of a broader, but still incomplete, business tax reform programme.
The debt/equity rules have retrospective application to all instruments issued since July 1 2001. Instruments issued prior to that date have effectively been grandfathered until June 30 2004 unless the issuer elects for the new rules to have immediate application. The rules look at whether there is a provision of finance and whether the repayment of the amount is economically unavoidable.
This in-substance approach and the delay in amending the foreign source income rules, which by contrast adopt legal form, lead to a number of interesting issues and opportunities, particularly with cross-border financial instruments (given the lack of international consensus in this area).
The completely revamped thin capitalization regime will apply prospectively to all years of income commencing after June 30 2001. The rules not only apply to all foreign controlled entities deriving Australian income but, importantly, now also apply to all Australian entities with offshore operations.
Very broadly speaking, the rules provide that, to ensure full deductibility of interest and related costs, entities other than banks must keep their Australian debt levels below 75% of their net Australian assets, or pass an alternative arm's length test. Where the entity is a bank, it must ensure that it maintains a minimum equity level equal to 4% of its Australian risk-weighted assets, as calculated for prudential (regulatory) purposes.
Rory Lonergan and Tony Frost