Thin capitalisation: eroding asset values and increasing debt ... - PwC

TaxTalk – Electronic Bulletin of Australian Tax Developments
chosen by the taxpayer, but regardless
of the ‘averaging’ method chosen, the
year end balances must be included
in calculating the average. Taxpayers
should also be conscious of the ‘part
year’ rules inherent under the TC regime
which can result in the requirement to
determine the TC position for distinct
periods of the year during which the
taxpayer is differently ‘classified’ under
the provisions. The issue here is that
if in the present tax year, there is a
requirement to apply the provisions to
more than one period in the year, some
of the planning opportunities generally
available to taxpayers will only be able
to be applied to the period which is
still ‘open’.
Leaving aside the problems associated
with the ‘part year’ rules, the likely
problem that many taxpayers will face
in calculating their ‘safe harbour’ debt
amount for the current year is that in
the current economic environment, the
value of assets may have eroded to a
point where existing asset values will
be insufficient for the ‘safe harbour’
debt amount to support the level of
the taxpayer’s debt which gives rise to
‘debt deductions’. In other words, the
current economic environment may
have the effect of eroding asset values
to a point where ‘debt deductions’ will
be disallowed either wholly or in part.
The effect of this outcome may well
be a further reduction in net worth of
the taxpayer through the income tax
cost required to be recorded in the
financial statements.
A further problem that may be faced by
taxpayers this year relates to the recent
fall in value of the Australian currency
(relative to foreign currencies), since this
may have a detrimental impact on the
taxpayer’s balance sheet, particularly
where borrowings are denominated
in foreign currency and there is an
unrealised foreign exchange loss
required to be recorded. In this respect,
even if the debt is hedged, the value
of the debt to be measured against
the ‘safe harbour’ debt amount (or the
‘arm’s length’ debt amount if the arm’s
length debt test is chosen) will generally
be the value of the debt measured in
Australian currency, with no reduction
being made for the value of the ‘hedge
asset’. The ‘hedge asset’ would simply
be included in the value of assets taken
into account in determining the ‘safe
harbour’ debt amount. Whilst with a fully
hedged liability no adverse impact on
the taxpayer’s balance sheet would arise
from translating amounts to Australian
currency, the fact that under the safe
harbour method, only 75 per cent of
the value of ‘included’ assets are taken
into account, means that the value of
the hedge asset taken into account will
only be 75 per cent of the additional
debt value arising because of the foreign
currency restatement.
On the asset side of the balance sheet,
whilst the fall in currency value may
increase the carrying value of foreign
assets, since equity investments held
in controlled foreign entities are excluded
from assets used by the taxpayer in the
calculation of ‘safe harbour’ debt, any
increase in the value of these assets
because of movements in the value of
the Australian currency will provide no
benefit to the taxpayer in calculating
‘safe harbour’ debt.
Not surprising, with the present volatility
of financial markets, many taxpayers
are undertaking in-depth reviews
of their current TC position and are
considering strategies to reduce adverse
consequences through the denial
of tax deductions. Strategies being
considered include:
• equity injections and debt reductions
• repatriation of monies from
overseas jurisdictions
• applying the arm’s length test
• maximising concessions available
such as the associate entity debt
and controlled foreign entity debt
concessions
• reviewing selection of
averaging method
• revaluation of assets
Implementing some of these strategies
will present other tax issues that need to
be taken into account, and any strategy
adopted must be based on a proper
analysis of all inherent and associated
taxation implications for the taxpayer and
other affected entities.
Taxpayers should also be aware of
the Commissioner’s preliminary views
as to how the ‘safe harbour debt test’
interacts with the transfer pricing
provisions of Australia’s tax law.
We featured this issue in our February
2008 and July 2008 editions of TaxTalk.
In summary we noted in those articles
that the Commissioner in Draft Taxation
Determination TD 2007/D20 was of the
view, that the transfer pricing provisions
could be used to adjust the pricing
of ‘intra-group’ financial transactions
even if the taxpayer has a debt capital
structure that is within the ‘safe harbour’
debt amount determined under the TC
rules. Taxpayers with ‘intra-group’ debt
thus have an additional matter to take
into consideration in reviewing their TC
position for the current and future years.
Another matter to take into account
is that from 1 January 2009 many
taxpayers will be required to prepare
their ‘safe harbour’ statement of
assets and liabilities on the basis of
the Australian equivalent International
Financial Reporting Standards (AIFRS).
Presently, those taxpayers may choose
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