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

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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 PricewaterhouseCoopers :
TaxTalk – Electronic Bulletin of Australian Tax Developments to apply the former generally accepted accounting standards under transitional rules which were introduced some time ago. While it is difficult to generalise, there will no doubt be many taxpayers whose balance sheets are adversely impacted by the application of AIFRS to the TC calculations. Remedial action may need to be taken before 31 December 2008 to ensure that when the next tax year begins, the level of debt giving rise to ‘debt deductions’ is not excessive relative to the taxpayer’s ‘safe harbour’ debt position. In considering this issue, taxpayers should be aware of proposed changes to the TC rules which would: • prohibit the recognition for TC purposes of deferred tax liabilities and assets, and prohibit the recognition of the asset or liability recorded in the balance sheet in respect of a defined benefit fund (ie overfunded or underfunded obligations respectively) operated by the taxpayer, and • subject to complying with certain valuation requirements, permit entities (other than those treated as ADIs) to recognise for TC purposes the value of internally generated intangible assets and to revalue intangible assets where recognition and revaluation is currently prohibited under the accounting standards due to the absence of an ‘active market’. With respect to prohibiting the recognition of deferred tax balances, in the current environment where taxpayers may be incurring losses, this change to the law may have a material adverse impact on calculation of a taxpayer’s ‘safe harbour debt amount’. In case of prohibiting the recognition of defined benefit fund asset and liabilities, whilst this may be welcomed given the current values of listed securities, the fact that the changes will not apply for the year ending 31 December 2008 may pose a significant problem for taxpayers who are required to recognise defined benefit fund liabilities in their financial statements prepared under AIFS, and who choose not to use the transitional rules to prepare their ‘safe harbour’ statement of assets and liabilities. With the changing economic environment and the changes to the TC rules outlined above, constant review of the taxpayer’s position under these rules to avoid unexpected surprises has become a business norm. As TC is listed by the Commissioner as an audit focus area, demonstrating that the TC position has been correctly determined should take high priority on any taxpayer’s risk management matrix. Further discussion on the thin capitalisation rules was included in our year-end tax planning special edition of TaxTalk in June 2008. Please contact your PricewaterhouseCoopers adviser if you have any need for assistance. For further information, please contact your usual PricewaterhouseCoopers adviser, or: Peter Collins (03) 8603 6247 peter.collins@au.pwc.com Mike Davidson (02) 8266 8803 m.davidson@au.pwc.com Jim McMillan (08) 8218 7308 jim.mcmillan@au.pwc.com Warren Dick (08) 923 83589 warren.dick@au.pwc.com Review of tax arrangements applying to managed investment trusts On 29 October 2008, the Chairman of the Board of Taxation announced the release of a discussion paper on the Board’s review of the tax arrangements applying to managed investment trusts (MITs). The discussion paper is intended to facilitate ‘stakeholder’ consultation. The closing date for submissions is 19 December 2008. The following provides a high-level summary of the key issues the Board has identified in its review, as well as certain questions on which the Board is seeking ‘stakeholder’ submissions. Options for determining tax liabilities of MITs and beneficiaries Under the terms of reference applying to the review, the Board is required to explore alternatives for the taxation of trust income that are broadly consistent with five key policy principles: PricewaterhouseCoopers :
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