On 14 May 2013, the Treasurer, Wayne Swan, delivered his sixth Federal Budget. The 2013–14 Federal Budget has had to be framed to deal with the ‘perfect storm of torrid global forces and the high dollar that has smashed our budget revenues’. In his speech at the CEDA luncheon on 1 May 2013, the Treasurer identified the enduring strength of the Australian dollar as having the most impact on keeping domestic prices low and squeezing profit margins which in turn squeezes tax revenues.
While acknowledging the strength of Australia’s economy relative to the rest of the world, the Treasurer pointed out that Australia is facing some very difficult choices and a Budget that will be in deficit for longer than previously forecast. He identified the choices as being between supporting jobs and growth or driving the economy into the ground and putting tens of thousands of jobs at risk and concluded that the Budget would be crafted to support jobs and growth.
Despite this, it appears that most of the tax measures introduced in the 2013-14 Budget with respect to foreign investment both into and out of Australia are designed to discourage foreign investment in the form of:
- Reduced safe harbour limit from 3:1 to 1.5:1 on a debt to equity basis for general entities for the purposes of the thin capitalisation rules;
- Abolishing the deduction for interest on borrowings used to fund foreign investments; and
- Introduction of a 10% non-final withholding tax to apply to the disposal by foreign residents of certain taxable Australian property (which is not limited to real property).
Thin cap ratios reduced
The Government announced that it would address profit shifting by multinationals through the disproportionate allocation of debt to Australia by tightening and improving the integrity of several aspects of Australia's international tax arrangements, with effect for income years commencing on or after 1 July 2014.
The changes announced to thin capitalisation in the Budget include, amongst others:
- increasing the de minimis threshold from $250,000 to $2m of debt deductions which is designed to reduce compliance costs for small business; and
- for general entities the safe harbour limit will be reduced from 3:1 to 1.5:1 on a debt to equity basis (or 75% to 60% on a debt to total asset basis).
The proposed changes to the thin capitalisation provisions was previously announced and expected. The changes would effectively increase the effective tax rates for taxpayers going offshore and reduces Australia’s attractiveness as a destination for offshore multinationals.
Those entities that fall within the threshold levels should re-assess their thin capitalisation positions. This could be done by reducing debt or re-valuing assets. Alternatively, entities should consider re-capitalising to prevent the denial of interest expenditure.
Deduction for interest on borrowings used to fund foreign investments abolished
Under the current rules, section 25-90 of the Income Tax Assessment Act 1997, allows (in most circumstances) an entity to deduct interest when investing in offshore entities. This is despite the fact that the income that is earned, as dividends or the repatriation of branch profits, may be non-assessable, non-exempt (NANE) income. This deduction is now being abolished and the deduction will not be allowed as from Jul 2014. This is a significant development which will affect all taxpayers using debt to expand offshore (offshore includes New Zealand!).
Prior to 2001 (when section 25-90 was introduced), Australian companies were required to trace debt to ensure interest deductibility. The abolition of section 25-90 means that the position pre-2001 is reinstated. This means that any Australian entity with a subsidiary or branch offshore would be required to distinguish between borrowings used to fund local operations and those borrowings used to fund offshore entities, otherwise potentially a portion of the interest expense incurred could be denied as a deduction. No details are available at this stage as to how any apportionment calculation would operate, however, clearly, in response to the Budget announcement, a review and possible restructuring of debt should be considered a priority in the coming months.
Further, note that the de minimus threshold applied to thin capitalisation deductions of $2m does not apply here. Consequently, a taxpayer can be allowed a debt deduction under thin capitalisation, but denied a deduction because they are using debt to go offshore.
Foreign resident CGT withholding tax
A 10% non-final withholding tax will apply to the disposal by foreign residents of certain taxable Australian property. In such cases, the purchaser will be required to withhold and remit 10% of the proceeds from the sale. Although to be implemented in the context of CGT, it will apply equally where the disposal of the Australian real property asset by the foreign resident is likely to produce gains on revenue account - and so be taxable as ordinary income rather than as a capital gain.
Currently, withholding taxes target interest, dividends and royalties, which are easily identifiable forms of income to non-residents. This new withholding tax will only apply from 1 July 2016. The Government thus appears to be giving itself plenty of time to legislate for the new withholding tax as, we believe, there are technical and practical difficulties in identifying the source of income and determining whether or not the income should be subject to withholding tax.
So this withholding tax will be something to watch out for as it may impose more administrative burdens on anyone dealing with non-residents.
Other changes affecting international tax dealings
The other significant change announced is that the non-portfolio dividend exemption (section 23AJ of the Income Tax Assessment Act 1936) will be extended to foreign non-portfolio dividends earned by trusts and partnerships. Currently, only non-portfolio (ie a 10% or more interest in foreign companies) dividends earned by companies is treated as NANE income. We will now need to identify similar interests held by trusts and partnerships.
In relation to CFC reform, we are still in a period of uncertainty. The Government initially announced changes to the CFC rules in the 2009-10 budget. We are now awaiting the OECD report on base erosion and profit shifting to see whether the reforms will progress further.
In general, this budget did not contain many changes to income tax issues affecting SME businesses. It was also designed not to surprise the business community. However, some fundamental changes were announced that affect any entity that operates cross-border. You should keep your eye on the ball as these proposals are debated, because if they are legislated and not taken into account, they could negatively impact your business.
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