NO.006

Today the Government is releasing an exposure draft of legislation that reforms the

thin capitalisation rules to ensure foreign and Australian multinationals pay a fair share

of tax in Australia.

The exposure draft legislation also introduces tests that make the borderline between

debt and equity more certain.

Thin capitalisation rules aim to prevent multinational taxpayers allocating a

disproportionate amount of debt to their Australian operations because of a more

favourable tax treatment of debt compared to equity. The rules do this by disallowing

deductions relating to excessive debt financing.

Current thin capitalisation rules are incomplete in that they cover only related party

loans and foreign multinational investors.

In line with the recommendation of the Ralph Review of Business Taxation,

Australia’s thin capitalisation rules are to be extended by applying them to total

debt and to Australian multinationals. For banks, the rules are based on capital levels

reported for regulatory purposes.

The measures will apply from 1 July 2001, but in the first year of operation entities

will have the choice of measuring assets, debts and other relevant amounts at the end of

the taxpayer’s accounting year.

Debt for thin capitalisation purposes is aligned with the reformed debt definition in

the exposure draft legislation released today.

In addition, the Income Tax Assessment Act 1936 will be amended to exempt from

interest withholding tax debentures issued by non-resident companies operating in

Australia through permanent establishments. The exemption will apply to interest on

debentures issued after 30 June 2001 and will also reduce compliance costs.

The Government has decided to implement the general approach recommended by the Ralph

Review of Business Taxation for determining whether an interest is debt or equity.

An interest will be debt, rather than equity, if there is a non-contingent obligation

to return the original investment. For interests whose terms exceed 10 years, the return

of the original investment will be measured in present value terms. In general, returns on

interests classified as debt are deductible and non-frankable.

In contrast, equity interests are generally characterised by returns that are

contingent on the economic performance of the issuer. The returns on equity interests are

generally frankable and non-deductible.

The exposure draft legislation will reduce uncertainty by providing a mechanism for

classifying debt-equity hybrids as either debt or equity. It is anticipated that most

converting notes (prior to conversion) will be classified as debt, while most converting

preference shares will be classified as equity. Income securities, which are essentially

non-cumulative, profit-contingent, perpetual instruments, will be classified as equity.

This new test provides a consistent and coherent basis for distinguishing between debt

and equity for the purpose of determining whether returns are frankable or not.

Subject to transitional arrangements referred to below, the new test is to apply to

returns on financing instruments made after 30 June 2001.

The Australian Taxation Office (ATO) has today released two draft taxation rulings on

income securities. These rulings clarify the treatment of certain income securities under

the current taxation law. As a result of the draft rulings, the deductibility status of

certain income securities is to be retained until the new debt/equity test becomes

operative, having regard to the transitional arrangements outlined below.

The Government has decided to provide a transitional rule, under which issuers of

income securities and equivalent instruments issued prior to this announcement can elect

to have the current law apply to returns paid before 1 July 2004. Issuers are required to

make this election before 1 July 2001.

If an issuer makes an election, returns on these securities will not be frankable until

1 July 2004. Deductibility will be determined under the current income tax law, taking

into account the date of effect of the ATO’s draft rulings. These securities will be

subject to the new thin capitalisation rules from 1 July 2001.

If an issuer does not make an election, returns on income securities and equivalent

instruments made on or after 1 July 2001 will be non-deductible and frankable in

accordance with the new definition set out above.

The exposure drafts and accompanying explanatory statement can be obtained from the

Treasury internet site (www.treasury.gov.au)

under ‘What’s New’.

Comments on thin capitalisation can be sent to:

Assistant Commissioner

International Tax Division – Business Tax Reform (Thin Capitalisation)

Australian Taxation Office

PO BOX 900

CIVIC SQUARE ACT 2608

or emailed to

thin.capitalisation@ato.gov.au

Comments on the debt/equity borderline can be sent to:

Assistant Commissioner

Law Design and Development – Taxation of Financial Arrangements

(Debt Equity Borderline)

Australian Taxation Office

PO BOX 900

CIVIC SQUARE ACT 2608

or emailed to:

debt-equity@ato.gov.au

Submissions on the exposure drafts should be received by 20 March 2001.

Submissions will be treated as public unless the author indicates to the contrary.

Submissions lodged electronically will be published on the Treasury website, unless it is

indicated that they are to be treated as confidential.

CANBERRA

21 February 2001