4 June 2013

Board of Taxation Reviews of the thin capitalisation arm's length test and Australia's debt and equity tax rules

In the 2013-14 Budget, the Gillard Government announced a package of measures aimed at protecting the integrity of our corporate tax system to ensure a stable source of revenue to fund vital investments in our economy and community, underpinning a stronger, smarter and fairer Australia.

These measures are consistent with the work the OECD is undertaking on tax base erosion and profit shifting and will build on the Australian Government's leading role in the G20's multilateral action to ensure international tax standards keep pace with the changing nature of global commerce.

As part of this package, the Government identified a number of areas of tax law that would require closer examination and consultation and as a result, commissioned the Board of Taxation to undertake two reviews.

Today, I am announcing the terms of reference for these two reviews.

Thin capitalisation arm's length test review

The first review will examine the arm's length debt test as it applies to the thin capitalisation rules to make it easier to comply with and administer, and to clarify in what circumstances the test should apply.

"In its current form, the arm's length test imposes high compliance costs on taxpayers and can be difficult for the Australian Taxation Office to administer," said Assistant Treasurer David Bradbury.

"The Board has been asked to make recommendations for modifying this test so that it is better targeted to reduce the scope for profit shifting and protect sectors with naturally higher gearing while reducing its compliance burden."

The terms of reference for this review are found in Attachment A. The Board is asked to provide its report to the Assistant Treasurer by December 2014.

Review of the debt and equity tax rules

The second review will combine a post-implementation review of the debt and equity rules with a consideration of whether there can be improved arrangements within the Australian tax system to address any inconsistencies between Australia's and other jurisdictions' debt and equity rules that could give rise to tax arbitrage opportunities.

The debt and equity tax rules were introduced in 2001 and focuses on the 'economic substance' of an arrangement to determine whether the arrangement is debt or equity for tax purposes.

"The 'economic substance' approach taken by Australia is not widely used in other jurisdictions," said Mr Bradbury. "As such, there may potentially be unintended misalignments with other provisions in the law which would result in policy inconsistencies."

The terms of reference for this review are found in Attachment B. The Board is asked to provide its report to the Assistant Treasurer by March 2015.

As part of both reviews, the Board will consult extensively with stakeholders.


Attachment A

Terms of Reference — Review of the Thin Capitalisation Arm's Length Test

  1. The Board of Taxation (the Board) is asked to undertake a review of the thin capitalisation arm's length test contained in Division 820 of the Income Tax Assessment Act 1997.
  2. The arm's length test is intended to provide a carve-out from the thin capitalisation rules for a level of debt which is considered to be 'commercial or independent'. The arm's length test focuses on what the business acting at arm's length would borrow and what independent commercial lenders would lend to the business (the policy).
  3. Having regard to the policy, the Board is to consult on ways to make the arm's length test more effective by reducing compliance costs for business and making it easier for the Australian Taxation Office to administer.
  4. In addition, the Board should consider who should be eligible to access the arm's length test and in what circumstances.
  5. The Board should consider views put forward and provide its recommendations in a report to the Government by December 2014.

Attachment B

Terms of reference — post-implementation review of the debt and equity tax rules

  1. The Board of Taxation (the Board) is asked to undertake a post-implementation review of the debt and equity rules in the income tax law (Division 974 of the Income Tax Assessment Act 1997).
  2. The debt and equity rules were introduced to classify certain financing arrangements as debt or equity for specified tax purposes (for example, the thin capitalisation rules and the interest and dividend withholding rules) on the basis of the 'economic substance' of the arrangement rather than merely on the basis of the legal form. The rules have now been in operation for over a decade.
  3. The standing terms of reference for a post-implementation review requires the Board to consider whether the legislation:
    • gives effect to the Government's policy intent, with compliance and administration costs commensurate with those foreshadowed in the Regulation Impact Statement for the measure;
    • is expressed in a clear, simple, comprehensible and workable manner;
    • avoids unintended consequences of a substantive nature;
    • takes account of actual taxpayer circumstances and commercial practices;
    • is consistent with other tax legislation; and
    • provides certainty.
  4. In undertaking the post-implementation review, the Board is also asked to:
    • examine whether there are any unintended misalignments between the debt and equity distinction and related concepts in the income tax law which could potentially result in inconsistent policy outcomes; and
    • consider whether there can be improved arrangements within the Australian tax system to address any inconsistencies between Australia's and other jurisdictions' debt and equity rules that could give rise to tax arbitrage opportunities.
  5. To the extent that there are unintended misalignments between the debt and equity distinction and related concepts in the income tax law, the Board should also examine the potential for broader application of the current debt and equity rules to ensure consistent policy outcomes.

The Board is asked to report to the Assistant Treasurer by March 2015.