On 16 October 2014, with minimal fanfare, the Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014 received Royal Assent.
The Act has amended the ITAA 1997 and other Acts to:
- tighten the debt limit settings in the thin capitalisation rules to ensure that multinational corporations do not allocate a disproportionate amount of debt to their Australian operations;
- increase the thin capitalisation de minimus threshold from $250,000 to $2 million;
- introduce a new thin capitalisation worldwide gearing test for inbound investors;
- reform the exemption for foreign non-portfolio dividends by repealing s. 23AJ and rewriting it into the ITAA 1997;
- amend the Principal Asset Test (PAT) in s. 855-30 of the ITAA 1997 to prevent double counting of certain non-taxable Australian real property assets;
- make a technical correction to the way in which ‘permanent establishment’ (PE) is defined for the purposes of s. 855-15 of the ITAA 1997 to ensure that foreign residents are subject to CGT on CGT assets that are used in carrying on a business through a PE in Australia; and,
- require the Commissioner to provide every applicable taxpayer with a tax receipt that sets out the notional distribution of the individual’s assessed income tax liability to different types of government expenditure.
Items 2 and 4 above are of particular interest to small to medium sized enterprises as these are the ones which might impact clients with offshore activities. We have summarised these two changes below.
Item 2: Thin Capitalisation
The thin capitalisation amendment increasing the de minimus threshold from $250,000 to $2,000,000 of debt deductions is a welcome move.
The thin capitalisation calculations are complex and burdensome for many small to medium enterprises, and the change from a 3:1 debt:equity ratio to a 2:1 ration could have increased this burden.
To illustrate the effect of this change and based on an example borrowing rate of 4.5%, the former de minimus threshold essentially allowed borrowings of $5.55 million. The increase of the de minimus threshold to $2 million now allows borrowings of up to $44.44 million without the provisions applying.
Increasing the de minimus threshold will relieve the thin capitalisation compliance burden for many small to medium enterprises.
Item 4: Repeal of section 23AJ and introduction of Subdivision 768-A
Subdivision 768-A of the Income Tax Assessment Act 1997 (ITAA 1997) treats a foreign equity distribution as non-assessable non-exempt (NANE) income if the recipient:
- is an Australian corporate tax entity (other than a company in the capacity of a trustee); and
- holds a participation interest of at least 10% in the foreign company making the distribution.
This NANE treatment applies whether the foreign equity distribution is received directly from the foreign company or indirectly through one or more interposed trusts or partnerships. Previously the distribution had to be directly received by an Australian company.
A foreign equity distribution is a distribution or a non-share dividend made by a foreign company in respect of an equity interest in the company.
The participation test requires the Australian corporate tax entity to have a participation interest of at least 10% in the foreign company making the distribution. This test is applied on the day the distribution or non-share dividend is “paid” or taken to be paid
a “participation interest” is the sum of the following amounts:
- the taxpayer’s direct participation interest in the foreign company. This is the total interest that the taxpayer directly holds in the company at the time the foreign equity distribution is made; and
- the taxpayer’s indirect participation interest in the foreign company. This is the proportion of ownership or control the taxpayer has in the company through one or more interposed trusts or partnerships at the time the foreign equity distribution is made.
The taxpayer passes the participation test if the sum of the taxpayer’s direct and indirect participation interests in the foreign company is 10% or more.
A trust will include the dividend as part of its assessable income and it will form part of the trust’s net distributable income calculation.
If this component of the trust’s net income is distributed to a company, then the provisions of Subdivision 768-A of the ITAA 1997 will operate to treat the amount as NANE for the company receiving the distribution where the relevant conditions are met.
Implications of the new subdivision
The provisions of Subdivision 768-A essentially allow non-portfolio dividends received by an Australian corporate entity from a foreign company to be tax free whether received directly or indirectly via a trust or partnership.
The previous section 23AJ exemption only applied where the foreign company’s shares were directly held by an Australian resident company.
The amended measures recognise the fact that there is no real economic disparity between non-portfolio dividends from non-resident companies being received directly by an Australian resident company as opposed to being received by an Australian resident company indirectly via an interposed entity.
In many cases Australian resident companies established to acquire non-resident company holdings are themselves owned by a family trust. From a structuring perspective, many small to medium enterprise family business groups will already have trust structures that could be utilised to acquire non-resident company shares.
Allowing the operation of the non-portfolio dividend exemption to operate on a look through basis avoids the cost an extra administrative burden of having to establish a new company to hold the shares.
Given the above amendments, practitioners that have clients with borrowings subject to the thin capitalisation rules should review their clients’ situation so as to determine whether they will now fall outside the rules due to the de minimus threshold increase.
Practitioners that have clients with business operation wishing to expand off-shore are now no longer restricted to holding their offshore company shareholdings directly by an Australian resident company in order to access the non-portfolio dividend exemption.
This may assist parties wishing to pool their investment by allowing off-shore company shares to be held in a unit trust of which the investors (or their associate entities) are unit holders or directly via discretionary trusts thus allowing them to deal directly with their non-portfolio dividend entitlement.