The thin capitalisation rules apply to Australian entities investing overseas, their associated entities, foreign controlled Australian entities and foreign entities investing directly into Australia. Under the rules, the amount of debt used to fund those Australian operations or investments is limited.
Multinational businesses often finance their Australian business investments with large amounts of overseas debt instead of equity as it is more tax effective for the following reasons:
- Subject to compliance with the thin capitalisation rules the interest expense is deductible against the Australian businesses profits. Each $1.00 of interest expense saves $0.285 or $0.30 in tax.
- The interest expenses payable to non-residents is only subject to a final 10% withholding tax.
The ATO defines a thinly capitalised entity as one whose assets are funded by a high level of debt and relatively little equity. These are entities whose investments are funded by $3 of debt for every $1 of equity. Where the debt exceeds 75% of the net value of the investments, then part of the interest expense will be non-deductible.
Businesses that have foreign interest expense deductions of less than $2m per year are excluded from the thin capitalisation rules. That means these businesses can be financed with 100% overseas debt. These businesses often end up with no Australian taxable income or tax liability after paying the foreign interest expense.
In addition, the interest expenses incurred in relation to financing rental property investments is excluded from the thin capitalisation rules. This means rental property investments can be funded with 100% debt.