Thin Cap Requirements
As these studies show, thin capitalization rules can have a variety of negative economic effects, such as less investment, fewer jobs, and lower market values of companies. When developing cap-and-limit rules, countries therefore face a trade-off between negative economic impacts and limiting base erosion. There are two threshold criteria that ensure that companies with relatively low debt deductions or small foreign investments are not subject to thin capitalization regulations. There is also a third test for some companies created to manage certain risks. The difficulties faced by taxpayers due to thin capitalisation rules have been further exacerbated by the difficulties encountered during the Covid-19 pandemic. Some businesses have suffered significant losses for a variety of reasons. In order to ensure the survival of these enterprises and to ensure sufficient working capital needs, MNE Groups may provide support through loans. Such an increase in debt, combined with losses (or negligible gains), can adversely affect interest deductibility for many taxpayers. Remember that every year you need to consider the thin capitalization rules.
You are not affected by thin capitalization rules for a specific income year if you meet one of the following criteria: Thin capitalization rules affect both Australian and foreign companies that have multinational investments. This means that they apply to: Under thin capitalization rules, the amount of debt used to fund the Australian operations of foreign companies investing in Australia and Australian companies investing overseas is limited. The rules prohibit the deduction of a portion of specified expenses incurred by a business in connection with its debt financing; That is, his deductions for debts. The rules apply when the company`s leverage exceeds certain limits. The Organisation for Economic Co-operation and Development (OECD) has indicated that multinational corporations may have some small-cap companies that perform favourably on tax terms, which is now a global problem. To address this issue, known as Base Erosion and Profit Shifting (BEPS), an initiative by the OECD and G20 countries adopted Action Report 4, Limiting Base Erosion through Interest Deductions and Other Financial Payments. For the calculation of the averages of small-cap amounts, the choice of other measurement periods may allow some smoothing of values in situations where significant differences have occurred during the income year. The debate on the taxation of multinational corporations and international tax rules in general has drawn new attention to thin capitalization rules. The OECD Action Plan on Base Erosion and Profit Shifting (BEPS), in particular Action 4, addresses the problem of profit erosion through interest deductions and other financial payments. In its 2015 final report on Measure 4, the OECD recommended the earnings stripping rule as an exemplary measure to limit interest deductions. More specifically, the OECD recommends setting the limit on interest deductions in a ratio between 10% and 30% of EBITDA. This bandwidth is provided “to ensure that countries apply a fixed quota low enough to combat base erosion and profit shifting, recognizing that not all countries are in the same situation.” As of April 2019, 17 of the 36 OECD countries had characteristics similar to the OECD`s recommended income reduction measure.
Debt and equity are two main sources of financing for any business. A combination of debt and equity in a commercial organization`s capital structure depends on a variety of factors, such as the capital intensity of the industry in which it operates, risk appetite, ability to raise leverage, and legal, business, and tax considerations. In general, a company financed by comparatively higher debt relative to equity is considered a low-capitalized company. However, thin capitalization rules not only limit the transfer of international debt, but can also have an impact on real economic activity. Traditional corporate tax systems allow tax deductions on interest payments but not on the cost of equity, thus favouring debt over equity financing. This is called debt bias. By capping deductible interest, thin capitalization rules eliminate the preference for debt over equity above a certain threshold. For some companies, this reduces the optimal leverage ratio and increases the share of equity financing.