Thin Capitalization & Risk Assessment

Learning CentreThin Capitalization & Risk Assessment

Thin Capitalization & Risk Assessment 

The thin capitalisation rules aim to prevent overseas companies from minimising their Australian tax liabilities by making excessive Australian interest deductions for their Australian operations. Several factors must be taken into account to determine whether (and how) debt and equity are appropriately attributed to the taxpayer and these rules are complex. There are specific rules under the regime to determine whether an arrangement is a debt or equity arrangement, thereby calculating the amount of debt versus equity, including whether a debt arrangement meets the “arm’s length condition” test for transfer pricing purposes.

Below this line are ways to explain different levels of debt to the ATO. Let's start with the thin capitalisation rules which say that a taxpayer has a safe harbor level of debt of 1.5 to 1 of equity, meaning that for every AUD 100 of equity, the entity is allowed AUD 150 of debt. If that level is exceeded, then the entity has recourse to either the arm's length level of debt test or the worldwide gearing test.

Australia generally adopts a staged approach in selecting taxpayers with transfer pricing issues for further risk review and audit. The ATO has a well-developed data-driven approach to identifying different kinds of transfer pricing risks at several levels, including algorithms that apply profits tests, identify restructures and transfers of IP, transactions with low-tax countries, cost of services, excessive interest rates on debts.

Further review is candidates normally allocated to a risk-assessment process where the taxpayer is often contacted for their transfer pricing compliance or their transfer pricing arrangements. Concerns raised at that stage may be addressed in an audit where further questions of the functions performed. A transfer pricing audit often—but not always—results in a tax adjustment, where penalties and interest also apply.