Hanlon, Dean --- "Thin Capitalisation Legislation and the Australia/United States Double Tax Convention: Can They Work Together?" [2000] JlATax 2; (2000) 3(1) Journal of Australian Taxation 4

	Home \| Databases \| WorldLII \| Search \| Feedback Journal of Australian Taxation

Thin capitalisation entails non-resident investors providing finance to resident corporations primarily through debt as opposed to equity in order to minimise tax payable. Australia has introduced specific provisions with the objective of deterring such practices. These provisions adopt the fixed ratio approach to deter thin capitalisation.

Double tax treaties, however, also govern cross-border transactions as nations seek to remove any double taxation associated with overlapping tax jurisdictions. It is the objective of this article to analyse both Australia's thin capitalisation legislation and the Australia/United States Double Tax Convention to determine whether any inconsistencies exist in the regulation of cross-border transactions. This analysis illustrates the existence of inconsistencies, as the implementation of the fixed ratio approach fails to consider whether cross-border transactions are arm's length in nature.

The possible courses of action available to overcome such incompatibility in the regulation of cross-border transactions are also examined.

1. INTRODUCTION

There are two primary ways in which a corporation can be financed by investors - through equity or debt. Where non-resident investors, most often multinational groups ("MNGs")^[1] are considering cross-border investment, the choice of the mix between equity and debt in the capital structure of a resident subsidiary corporation is influenced by tax considerations.^[2] The term "thin capitalisation"^[3] refers to those resident subsidiary corporations financed by MNGs primarily through debt as opposed to equity due to the tax advantages.

The tax benefits associated with injecting debt instead of capital into an Australian resident subsidiary corporation's capital structure are best illustrated by the following example.

	100% EQUITY $	100% DEBT $
Profit before interest and tax	1,000	1,000
Interest on loan	-	(1,000)
Profit before tax	1,000	-
Company tax expense	(360)	-
Profit available for appropriation	640	-
Dividend/Interest distributed	640	1,000
Withholding tax rate	0%	10%
Withholding tax	-	(100)
Amount received by MNG	640	900
Effective tax rate in Australia	36%	10%

As illustrated, profits generated by a resident subsidiary corporation are subject to company tax in Australia, provided the resident subsidiary corporation is capitalised with equity. Financing by way of debt, however, permits profits to be distributed to a MNG without the payment of company tax. This is because the payment of interest, in the absence of rules to the contrary, is deductible to the resident subsidiary corporation, thereby representing a distribution out of before tax profits.

Thus, a resident subsidiary corporation may be issued debt by a MNG as a substitute for what otherwise would be an equity investment in order to gain access to the interest deduction and consequently to eliminate the obligation to pay company tax in the subsidiary's country of residence.^[5]

Taxation authorities throughout the world have become increasingly aware of the possibility of non-resident investors minimising their exposure to national taxes by applying thin capitalisation strategies^[6] and, as a consequence, have acted accordingly by introducing specific anti-avoidance legislation limiting the tax benefits to be obtained from indebtedness to non-residents.^[7]

The existence of thin capitalisation is a consequence of the growing integration of economic activity at an international level.^[8] That is, the creation of a global economy has resulted in nations being regularly linked by cross-border transactions. A pervasive problem of such globalisation is the existence of overlapping tax jurisdictions. Each nation in the world asserts the right to tax income earned within its borders, irrespective of the residency of the taxpayer involved. Furthermore, many nations assert the right to tax residents, being individuals and corporations, regardless of where the income is earned.^[9]

In order to reduce the tax burden associated with overlapping tax jurisdictions, numerous double tax treaties have been created between nations. Seeking to co-ordinate international taxation, one of the premises of a double tax treaty is to ensure a taxpayer is not subject to double taxation as a consequence of cross-border transactions.^[10]

Of particular concern, however, is whether provisions implemented by national taxation authorities to deter thin capitalisation practices are inconsistent with existing double tax treaties and, as a consequence, prevent the avoidance of double taxation from being accomplished.^[11] In light of this, it is the objective of this article to critically analyse the operation of Australia's thin capitalisation legislation in accordance with the Convention Between the Government of Australia and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income ("Australia/United States Double Tax Convention"). Operative from 16 August 1982, the Australia/United States Double Tax Convention is of particular importance for two reasons. First, cross-border transactions between both countries are prevalent, thereby providing vast opportunities for thin capitalisation practices to arise.^[12] Second, the Australia/United States Double Tax Convention is a prime illustration of the conflict that exists between double tax treaties Australia is a party to and Australia's thin capitalisation provisions.

The balance of this article is divided into 6 sections. Section 2 provides a critical analysis of the thin capitalisation provisions enforced by Australian taxation authorities. Section 3 describes the alternative approaches available to Australian taxation authorities in the attempt to deter thin capitalisation. Section 4 examines the importance of double tax treaties within Australia, with particular reference to the legislative force of the Australia/United States Double Tax Convention. In light of this, section 5 illustrates how the approach adopted by Australia to deter thin capitalisation is inconsistent with the Australia/United States Double Tax Convention. Section 6 provides conclusions and recommendations to ensure inconsistencies between Australia's thin capitalisation provisions and the Australia/United States Double Tax Convention are overcome.

2. THIN CAPITALISATION LEGISLATION WITHIN AUSTRALIA

Originally, Australia's thin capitalisation regulations were contained within its foreign investment legislation. More specifically, the Foreign Takeovers Act 1975 (Cth), administered by the Foreign Investment Review Board ("FIRB"), imposed restrictions on foreign investments in Australia, as foreign investors were required to maintain approved debt to equity ratios. For example, the FIRB prevented foreign investment in Australia unless the non-resident investors could demonstrate foreign debt would not exceed three times (six for financial institutions) the foreign equity of the resident corporation.^[13]

As time progressed, however, the Federal Government sought to limit the responsibilities of the FIRB in order to attract foreign investment. As a result of restricting the FIRB's powers, it was no longer feasible for the FIRB to administer thin capitalisation regulations.^[14] Furthermore, the deregulation of the Australian financial system in the early 1980s resulted in a significant increase in the number of cross-border transactions. This brought with it the risk of a reduced national tax base as a number of foreign investors resorted to investment by way of more tax effective debt than equity.^[15] It was due to this that thin capitalisation provisions were inserted into the ITAA36.

ITAA36, Part III, Div 16F, ss 159GZA to 159GZX represent the provisions governing thin capitalisation in Australia.^[16] Introduced by the Taxation Laws Amendment Bill (No.4) 1987 (Cth) ("TLAB87"), such provisions apply to resident companies, resident company groups, partnerships, trusts and estates on debts due to foreign controllers from the year of income commencing on 1 July 1987.^[17] Perhaps the best way to summarise the application of the thin capitalisation provisions is to examine the Explanatory Memorandum to TLAB87:

Thus, the thin capitalisation provisions prevent Australian taxpayers from deducting as a business expense "excessive" interest payments to foreign controllers.^[19] Whilst it is recognised that the thin capitalisation provisions are applicable to several entity types, this article shall focus primarily on companies.

2.1 Foreign Controller

In the case of a resident company, a non-resident is a foreign controller if, either alone or together with associates:^[20]

Provisions enabling relevant control or entitlement to be traced through interposed entities extend the scope of these requirements (ITAA36, s 159GZJ(1)). ^[22]

Assume non-resident X holds 30% of the shares in resident company Y, which holds 30% of the shares in resident company Z. X would be a foreign controller in relation to Z. Although X has only a 9% indirect beneficial interest (less than the 15% minimum threshold) in Z, by virtue of control over Y, X is capable of controlling 30% of votes in Z.

Excessive interest payments are taken to mean those payable on money advanced by a foreign controller which exceed a prescribed multiple of the foreign controller's equity investment in the resident (ITAA36, s 159GZS(1)). As from 1 July 1997, this multiple is 2:1 for foreign controlled taxpayers other than financial institutions and 6:1 for financial institutions.^[23] Thus, an Australian company's indebtedness to a foreign controller (foreign debt) cannot exceed two times (six for financial institutions) that foreign controller's interest in the equity of the Australian company (foreign equity).^[24]

2.2 Foreign Debt

Foreign debt is defined to be amounts owing by the company, where interest is or may become payable:

As indicated by the definition above, interest-free debt does not form part of foreign debt.^[25] With regard to interest bearing trade debts, such indebtedness shall not be treated as foreign debt until such time as the interest actually becomes payable. To illustrate, Income Tax Ruling IT 2479 provides that:

Amounts, which become owing to foreign controllers through one or more resident or non-resident intermediaries, ("back-to-back loans") constitute foreign debt for thin capitalisation purposes (ITAA36, s 159GZO).^[27]

Assume non-resident X, which has 100% control of resident company Y, deposits funds with a financial intermediary, such as a bank, upon which interest is payable. If this deposit is subsequently lent to resident company Y, a back-to-back loan is said to exist, whereby interest payable to the intermediary is deemed to be interest payable to the financial controller.

Furthermore, amendments that have taken effect as from 1 July 1997 due to the Tax Laws Amendment Act (No.4) 1997 (Cth) stipulate all third party debt that is guaranteed by a foreign controller is to constitute foreign debt. Thus, funds lent by an arm's length source to a resident company, which are guaranteed or secured by the foreign controller of the resident company, are to be included within the definition of foreign debt.^[28] This amendment overcomes a major deficiency of the thin capitalisation provisions of Australia. Guaranteeing third party debt has historically been seen as an attractive option to foreign controllers.^[29] This is for two primary reasons. First, it is an alternative to equity financing. This is particularly important given distributions of profit, in the form of dividends, are taxed at the corporate rate, whilst the distribution of interest to an intermediary is deductible to the resident company. Second, until recently, such financing did not constitute foreign debt.^[30] Thus, by incorporating such amounts in the definition of foreign debt, an opportunity for foreign controllers to circumvent the thin capitalisation legislation has been eliminated.^[31]

2.3 Foreign Equity

Consider the following balance sheet extract of XYZ Ltd, an Australian resident company, which is not a financial institution, in which a foreign controller has an 80% interest (all expressed in Australian dollars):

		$
Issued and paid-up capital		10,000,000
Share premium reserve		3,000,000
Asset revaluation reserve (beginning of year)		4,000,000
Retained earnings (beginning of year)*		2,000,000
TOTAL EQUITY		19,000,000
Property, plant and equipment		11,000,000
Borrowing advanced to foreign controller		8,000,000
TOTAL ASSETS		19,000,000
* 1,200,000 of this amount is attributable to a bonus share issue.
Foreign equity is established as follows:
Issued and paid-up capital	10,000,000 @ 80%	8,000,000
Share permium reserve	3,000,000 @ 80%	2,400,000
Retained earnings **	2,000,000 @ 80%	1,600,000
		12,000,000
** Being less than the amount within the asset revaluation reserve.
Less;
Retained earnings due to bonus share issue		1,200,000
Borrowing advanced to foreign controller		8,000,000
FOREIGN EQUITY		2,800,000

One problem associated with determining foreign equity under the Australian legislation exists when a foreign controller, or non-resident associate, has an indirect interest in a resident operating company through a resident holding company. If such a scenario does exist, the resident operating company is severely restricted in seeking finance from the foreign controller or non-resident associate.^[32]

Assume a foreign controller holds a 100% direct interest in a resident holding company, of which that holding company holds 80% of the shares in a resident operating company. Whilst the foreign controller has an 80% interest in the resident operating company, the resident operating company is deemed to have no foreign equity. Thus, the operating company cannot obtain finance from the foreign controller or non-resident associate.

2.4 Excessive Interest

Upon foreign debt and foreign equity being issued in a company wishing to claim interest deductions, it must be determined whether the company has exceeded its allowable debt to equity ratio, thereby limiting such interest deductibility (ITAA36, s 159GZS).^[33] A company will be disallowed a deduction for a proportion of otherwise deductible foreign debt interest, if the daily average foreign debt for the company during the year exceeds two times (six for financial institutions) the foreign equity of the resident company.^[34] This is demonstrated by the following formula:^[35]

Consider the following information in relation to XYZ Ltd, an Australian company that is not a financial institution (all expressed in Australian dollars):

	$
Interest expense in relation to foreign debt for the year	900,000
Foreign equity for the year	1,500,000
Number of days on which foreign debt exceeded foreign equity product	183 days
Average daily foreign debt on these days	4,500,000
Average daily foreign debt for the year	4,000,000
Calculation of interest expense to be disallowed is as follows:
Disallowed interest = $168,750^[36]

Given the regulations governing cross-border transactions within Australia have been considered, it is now appropriate to examine the alternative approaches available to Australian taxation authorities in the deterrence of thin capitalisation.

3. ALTERNATIVE APPROACHES TO DETER THIN CAPITALISATION

In 1987, the OECD issued a report in which broad policy recommendations on the nature of domestic legislation to combat thin capitalisation practices were made.^[37] In this report, the OECD recognised two primary approaches, being a "flexible/arm's length approach" and a "fixed ratio approach", to deter thin capitalisation.

Furthermore, in 1996, the 50th Annual Congress of the International Fiscal Association ("IFA") recommended an approach to deter thin capitalisation practices, which encompassed a combination of the above two approaches.^[38] While only of persuasive authority to those members of IFA, the "combination approach" is relevant as it promotes an approach slightly different to, but derived from, the flexible/arm's length and the fixed ratio approaches.

It is the objective of this section to critically analyse these approaches, as the alternative implemented by national taxation authorities significantly impacts upon whether the resultant thin capitalisation provisions are in conflict with existing double tax treaties.

3.1 Flexible/Arm's Length Approach

The flexible/arm's length approach views the capitalisation of a corporation very much according to the particular facts and circumstances of each case. This entails national taxation authorities seeking "to decide what is the real nature of the payment [apparent interest expense] in light of reason and the general observation of commercial activity"^[39]. That is, consideration is to be given to various economic factors, such as economic climate, with particular regard to current interest rates, and commercial factors, such as industry type, in determining the real nature of interest payments.^[40] Fundamentally, the principal question to be answered is whether an independent person would have provided such a high proportion of the capital of the resident corporation in the form of debt.^[41] If the answer is yes, thin capitalisation does not exist. If not, the result of such thin capitalisation practices is to treat the payment as a dividend, which as a consequence, is non-deductible to the resident corporation. As the payment is re-classified as a dividend, the payment may also be subject to dividend withholding tax.

The OECD, in describing the operation of the flexible/arm's length approach, endorsed its implementation by national taxation authorities.^[42] This is for a number of reasons. First, unlike a fixed ratio approach, which is considered below, a flexible approach recognises different industries have differing capital requirements. That is, it is acknowledged debt requirements are not consistent across industries.^[43] To illustrate, what a service firm can support by way of borrowings may be vastly different from a manufacturing concern. The flexible approach to thin capitalisation recognises this by analysing the facts of each case, as opposed to adopting a fixed, uniform ratio applicable to all. Second, adopting such a flexible approach avoids the possibility of a fixed ratio becoming out of alignment with the actual position that lenders may adopt because of changing economic conditions.^[44] Thus, it overcomes the requirement of keeping up to date with changing economic conditions, which is necessary to ensure a fixed ratio does not become outdated in contemporary times.

Whilst advocated by the OECD, the flexible/arm's length approach has not been widely adopted in practice.^[45] This may be due to two primary reasons. First, such an approach may be considered subjective and fail to offer certainty to non-resident shareholders.^[46] That is, such flexibility may result in transactions being challenged in circumstances where the participants in the transaction may have been justified in believing the arrangement was tax effective. Without the existence of clear-cut guidelines to determine whether the transaction is tax effective or not, this may engender uncertainty and confusion amongst participants and ultimately result in a reluctance to provide finance to resident corporations. Second, whilst the flexible/arm's length approach acknowledges the differing commercial requirements across different industries, there may be no clear guidelines or benchmarks as to what are acceptable practices within each industry. As such, the determination of an appropriate debt to equity ratio within a particular industry may be highly subjective and represent nothing more than an estimate. ^[47]

3.2 Fixed Ratio Approach

This approach entails national taxation authorities regulating thin capitalisation practices by specifying a fixed ratio of what is an acceptable level of debt to equity applicable to all. Thus, if a resident corporation's proportion of debt to equity exceeds this specific ratio, thin capitalisation is said to exist. The alternative tax consequences available to national taxation authorities upon a breach of the debt to equity ratio can be divided into three categories.^[48] These are as follows:

3.2.1 Reclassification of Debt as Equity

The reclassification of debt, which exceeds the fixed debt to equity ratio, as equity results in interest upon such excessive debt effectively being treated as a distribution of profit^[49]. Such reclassification increases the resident corporation's profit and thus corporate tax liability. In addition, as a distribution of profit now exists, the dividend withholding tax regime is enforced.

3.2.2 Reclassification of Interest as a Hidden Profit Distribution

Like that of reclassifying debt as equity, the reclassification of interest as a hidden profit distribution or dividend produces the situation that would have arisen if the non-resident shareholder had provided finance in the form of equity. As a consequence, the reclassified interest (representing a dividend) increases the resident corporation's profit and hence the corporate tax applicable.^[50] Furthermore, as the interest is treated as a distribution of profit, the dividend withholding tax rate is applicable.

3.2.3 Determination of Non-deductible Portion of Interest

A further alternative tax consequence available to national taxation authorities upon a fixed debt to equity ratio being exceeded entails denying a deduction for the interest payments attributable to the excessive debt. Whilst interest remains interest for withholding tax purposes, a resident corporation's profit, and hence corporate tax liability, increases due to the non-deductibility component of interest.^[51]

Determination of the amount of non-deductible interest entails establishing the portion of interest paid on the loan capital provided by the non-resident shareholder, which exceeds the fixed debt to equity ratio. Thus, it is only interest in relation to the excessive component of debt provided by a non-resident shareholder, which is deemed non-deductible. ^[52]

Whilst in conflict with the recommendations made by the OECD as to the most appropriate approach to deter thin capitalisation, the fixed ratio approach has achieved widespread application.^[53] The primary reason for this is the determination of a fixed debt to equity ratio provides certainty, as both the non-resident shareholder and resident corporation know exactly up to what level of debt interest will be deductible.^[54] In such a case, a non-resident shareholder may plan investment strategies with certainty, being less concerned at some later stage that national taxation authorities would challenge the capitalisation of resident corporations.

3.3 Combination Approach

IFA recommend an approach to deter thin capitalisation practices that combines the flexible/arm's length and the fixed ratio approaches. The recommendation is twofold. First, thin capitalisation legislation should be "as specific as possible and should in particular contain safe haven rules in order to create legal certainty".^[55] However, in addition to this a "taxpayer should be entitled to prove that in his specific circumstances a different debt to equity ratio is appropriate".^[56]

Thus, on the issue of the most appropriate approach to negate thin capitalisation, IFA recommend the use of a combination of the flexible/arm's length and fixed ratio approaches. That is, a fixed debt to equity ratio should exist, but only be used as a reference point subject to change if a particular taxpayer can prove that a more suitable debt to equity ratio is appropriate in the circumstances.

The proposed IFA recommendation accords with the notion of providing legal certainty yet allows some degree of flexibility. Thus, a combination approach utilises the recognised advantages associated with both the flexible/arm's length and fixed ratio approaches to thin capitalisation.

4. THE AUTHORITY OF DOUBLE TAX TREATIES IN AUSTRALIA

Double tax treaties that Australia is a party to are not self-executing. That is, they do not automatically become part of domestic law when first becoming operative.^[57] Thus, double tax treaties that Australia is a party to only have the force of law if explicitly enacted as part of the domestic law of Australia.^[58] Double tax treaties obtain such force of law by being enacted as part of the Income Tax (International Agreements) Act 1953 (Cth) ("IT(IA)A53"). Given this, Australian taxation authorities have an obligation, enforceable by law, to execute the provisions of the Australia/United States Double Tax Convention and ensure such provisions are complied with (IT(IA)A53, s 6(1)).

IT(IA)A53 governs the operation of double tax treaties in conjunction with Australia's thin capitalisation provisions by providing that the ITAA36 is incorporated into, and is to be read as one with the IT(IA)A53 (IT(IA)A53, s 4(1)). However, upon an inconsistency existing between both sources of authority, IT(IA)A53 takes precedence. To illustrate, IT(IA)A53 expressly provides:

In light of this, it is necessary to determine whether inconsistencies exist between the Australia/United States Double Tax Convention and Australia's thin capitalisation provisions. If so, such thin capitalisation provisions are deemed to be ineffective given the authority bestowed upon double tax treaties.

5. DOMESTIC LEGISLATION INCONSISTENCIES WITHIN AUSTRALIA

The inconsistencies between Australia's thin capitalisation legislation and the Australia/United States Double Tax Convention will be examined in three particular areas, with each being considered in turn.

5.1 Associate Enterprises - Article 9(1)

Termed the "associated enterprises article" within the Australia/United States Double Tax Convention, this article anticipates circumstances where, due to the existence of a commercial or financial relationship between enterprises in different countries, transactions may not be on an arm's length basis.^[60] That is, transactions between two or more enterprises are on terms or at prices that are not commensurate with those charged to independent enterprises in similar transactions.^[61]

Article 9(1) of the Australia/United States Double Tax Convention states that taxable income may be adjusted to a level that reflects that which would have been achieved by independent enterprises. Thus, it is the objective of Art 9(1) to ensure the tax consequences of all related party transactions are on an arm's length basis by enabling national taxation authorities to adjust taxable income to reflect this.^[62]

Applying Art 9(1) to the practice of thin capitalisation, if taxable income has not accrued to a resident enterprise because it has paid what it described as interest to an associated enterprise which has been deducted in determining its taxable income but, in an arm's length situation, the payment would not have been deductible as it effectively represents a dividend, then, in adjusting the taxable income of the resident enterprise to treat this payment as non-deductible, the Australian taxation authorities would be acting in accordance with Art 9(1).^[63]

Of particular concern, however, is whether the approach advocated by the Australia/United States Double Tax Convention and that stipulated within Australia's thin capitalisation provisions in the adjustment of taxable income are consistent. That is, whether the adjustment of taxable income under both sources of authority give rise to the same outcome.

Art 9(1) is fundamentally a reprint of Art 9(1) contained in the OECD Model Convention for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital ("OECD Model Convention"). Furthermore, Art 9(1) of the OECD Model Convention contains a commentary on how an article concerned with transactions between associated enterprises is to operate. As judicial authority exists supporting the use of the OECD Model Convention and commentaries as an aid to interpreting double tax treaties Australia is a party to,^[64] it is of particular relevance to outline the approach advocated by the OECD in accounting for transactions between associated enterprises. With regard to Art 9(1), the OECD Model Convention states that:

Thus, Art 9(1) does not prevent the application of domestic thin capitalisation rules provided these rules do not adjust the taxable income of the resident enterprise to an amount greater than an arm's length profit.^[66]

As examined earlier, Australia's thin capitalisation rules are based on a fixed ratio approach. That is, upon a fixed debt to equity ratio being exceeded, Australian taxation authorities deny a deduction for the interest payments attributable to the excessive debt. As a consequence, a resident corporation's taxable income increases due to the non-deductibility component of interest. Due to the inflexible nature of a fixed ratio approach, however, these rules do not adjust profits to an amount that would have been earned in an arm's length situation.^[67] That is, a fixed ratio approach to thin capitalisation ignores the nature of transactions in ensuring the specified ratio is satisfied.^[68]

This issue becomes important in the event of thin capitalisation legislation stipulating a strict debt to equity ratio yet the loan conditions agreed upon are of an arm's length nature. In such a situation the fixed ratio approach denies a reduction for interest payments on such borrowing even though the transaction is on an arm's length basis. Exhibiting a total disregard for the fact the transaction is of an arm's length nature illustrates the inability of Australian taxation authorities to comply with Art 9(1) in the implementation of a fixed ratio approach to thin capitalisation.

5.2 Excessive Interest - Article 11(4)

The operation of Art 11(4) of the Australia/United States Double Tax Convention is of a similar nature to that of Art 9(1) as it states that where, by reason of a special relationship between the payer and recipient of the interest, the amount of the interest paid exceeds the amount which would have been agreed upon by the payer and recipient had they stipulated at arm's length, the excessive amount of such interest shall be taxed accordingly.^[69]

Applying Art 11(4) to the issue of thin capitalisation, where a special relationship is said to exist between the resident borrowing corporation and the non-resident lender of the funds, any interest deemed excessive will be subject to tax in accordance with Australian taxation law.^[70]

Given Art 11(4) is based on the corresponding provision contained in the OECD Model Convention, being Article 11(6), it is appropriate to refer to the commentary of the OECD Model Convention in examining the practical operation of Art 11(4). A special relationship is taken to exist "where interest is paid to an individual or legal person who directly or indirectly controls the payer, or who is directly or indirectly controlled by him or his subordinate to a group having common interest with him"^[71]

The determination of what constitutes control, however, is not defined. As a consequence, it cannot be established if such control is consistent with determining the existence of a foreign controller as per Australia's thin capitalisation legislation.

Upon the existence of excessive interest, the commentary of the OECD Model Convention provides the following:

Based on this, Art 11(4) permits the disallowance of interest as a deduction but does not permit a reclassification of debt as equity.^[73] This is of little concern for Australian purposes as no reclassification takes place. What is of fundamental importance, however, is that Art 11(4) only permits the adjustment of interest rates to those charged in arm's length situations. Thus, where a rate of interest has been negotiated which differs from what would represent an arm's length rate, Art 11(4) applies.^[74]

Australia's thin capitalisation legislation, however, does not classify interest payable as excessive based on the rate of interest. Interest is deemed excessive based on the debt to equity ratio of a resident borrowing corporation. That is, interest is excessive for thin capitalisation purposes not due to the rate of interest but rather the amount of interest payable due to the specified debt to equity ratio being exceeded.

Consider the situation where the interest rate applicable to the borrowing is comparable to that of an arm's length rate, but the amount of such borrowing results in the specified debt to equity ratio being exceeded. Australia's thin capitalisation legislation would classify the interest payable as excessive given the specified debt to equity ratio has been breached. Article 11(4), however, would not deem the interest payable to be excessive as the rate of interest applicable to the borrowings is of an arm's length nature.

To enforce thin capitalisation legislation in such a situation would be in breach of the Australia/United States Double Tax Convention.

5.3 Non-Discrimination - Article 23(1)

Article 23(1) of the Australia/United States Double Tax Convention provides that interest (and other disbursements) paid by a resident to a non-resident shall be deductible for the purpose of determining taxable income under the same condition as if the interest had been paid to a resident.^[75] Thus, the deductibility of interest paid by a resident is not dependent upon, or influenced by, the residency of the recipient.^[76]

At face value, the thin capitalisation provisions implemented within Australia appear contradictory to Art 23(1) as such provisions are applicable only to payments made to non-residents.^[77] Thus, as such provisions are aimed at restricting the deduction of interest paid by Australian corporations to non-residents, these provisions appear in conflict with Art 23(1).

Article 23(1), however, does not apply to taxes that are reasonably designed to prevent avoidance or evasion of tax.^[78] That is, discrimination based on residency may apply where the purpose of such taxation is to prevent tax avoidance or evasion. Australian taxation authorities have argued thin capitalisation legislation is of an anti-avoidance nature and thus protected by the Art 23(2) exclusion.^[79] As a consequence, thin capitalisation legislation has no impact on Australia's treaty obligations with the United States.

However, like that of most articles within the Australia/United States Double Tax Convention, Art 23(1) is based on an article of similar content within the OECD Model Convention, being Art 24(4). In describing the operation of Art 24(4) of the OECD Model Convention, the OECD is of the opinion that the non-discrimination article would not in general prohibit thin capitalisation rules from applying provided that domestic law and specific treaty provisions refer to arm's length profits.^[80] Therefore, like that of Art 9(1) and Art 11(6) of the OECD Model Convention, Art 24(4) does not prohibit the operation of domestic thin capitalisation legislation provided taxable profits are adjusted to reflect the amount that would have been earned on an arm's length basis. ^[81]

Australia's thin capitalisation rules are based on a fixed ratio approach. Due to the inflexible nature of a fixed ratio approach, however, these rules do not adjust profits to an amount that would have been earned in an arm's length situation. That is, a fixed ratio approach to thin capitalisation ignores the nature of transactions in ensuring the specified ratio is satisfied. Exhibiting a total disregard for the fact the transaction is of an arm's length nature illustrates the inability of Australian taxation authorities to comply with Art 23(1) in the implementation of a fixed ratio approach to thin capitalisation. ^[82]

6. CONCLUSIONS AND RECOMMENDATIONS

Australian taxation authorities implement the fixed ratio approach in seeking to deter thin capitalisation practices. The implementation of the fixed ratio approach, however, does not result in the adjustment of profits to an amount that would have been earned in an arm's length situation.^[83] This is because upon the specific debt to equity ratio being exceeded, the fixed ratio approach denies a deduction for interest payments on related party borrowing even though such borrowing may be of arm's length in nature.^[84] As a consequence, the inflexible nature of the fixed ratio approach creates inconsistencies between Australia's thin capitalisation provisions and the Australia/United States Double Tax Convention.

Upon an inconsistency existing between both sources of authority, the authority of double tax treaties takes precedence. Thus, due to the inconsistencies that exist, Australia's thin capitalisation provisions are deemed to be ineffective given the authority bestowed upon double tax treaties.

It is therefore necessary to overcome such inconsistencies to ensure the Australia's thin capitalisation provisions have operative effect. Two possible courses of action are available to achieve this. One such course of action is the introduction of an arm's length approach to deter thin capitalisation. Supported by the OECD, an arm's length approach views the capitalisation of a corporation very much according to the particular facts and circumstances of each case. Such a perspective is in perfect harmony with double tax treaties, in particular the Australia/Double Tax Convention, as adjustments made to taxable profits in respect of thin capitalisation are only concerned with those transactions not of an arm's length nature.^[85] Therefore, the requirement that taxable profits cannot differ from that would have been achieved on an arm's length basis is satisfied.

Such a dramatic shift in belief as to the most appropriate deterrence of thin capitalisation is unlikely within Australia given its predisposition towards certainty as evidenced by current thin capitalisation rules.

Second, a less drastic measure is to implement a combined approach to deter thin capitalisation. Such an approach states thin capitalisation legislation should be as specific as possible and contain a fixed debt to equity ratio in order to create and promote legal certainty. However, in addition to this a taxpayer should have the opportunity to prove that, based on the facts and circumstances of the particular case at hand the debt to equity ratio may be exceeded. Such circumstances may include the related party transaction, which contributes to exceeding the debt to equity ratio, is arm's length in nature. Introducing such an exception, upon the debt to equity ratio being breached, therefore, enables thin capitalisation provisions to be compatible with double tax treaties as taxpayers are able to ensure only those related party transactions not of an arm's length nature represent thin capitalisation practices.^[86] Such an approach also provides a degree of certainty in the enforcement of the thin capitalisation provisions as a fixed debt to equity ratio is used as a benchmark or safe-harbour guideline.^[87]

The combination approach to thin capitalisation has achieved popularity in recent times with both Japan and South Korea adopting this approach.^[88] Introduced on 31 March 1992, Japanese thin capitalisation provisions provide that if the level of related party debt of a Japanese corporation exceeds three times its net assets, the corresponding interest expense will not be deductible in the derivation of the corporation's taxable income.^[89]

Whilst the thin capitalisation provisions prescribe a debt to equity ratio of 3:1, higher ratios are permitted based on comparisons with Japanese corporations of similar size and engaged in similar business.^[90] Thus, there is scope for a resident corporation to possess a higher debt to equity ratio than the 3:1 safe-harbour guideline, provided a comparable Japanese corporation has such a higher ratio.^[91] This promotes flexibility in the Japanese thin capitalisation legislation as it recognises different industries carry different risks.

Operative from 1 January 1996, South Korean thin capitalisation legislation^[92] provides that if a resident corporations borrowing exceeds 300% of the amount of the related party's equity in the resident corporation (600% for financial institutions), interest on the excessive debt is not deductible.^[93] South Korean thin capitalisation legislation, however, requires the determination of an industry specific debt to equity ratio based on factors such as industry risk and finance requirements.^[94] If the debt to equity ratio prevailing in the industry in which the resident corporation is carrying on business is proved to be higher than 300%, the industry ratio may apply for thin capitalisation purposes.^[95] Thus, there is scope for a resident corporation to possess a higher debt to equity ratio than the 300% safe-harbour guideline.

Such applications of the combination approach illustrate the popularity of this method and may represent a feasible alternative in overcoming the incompatibility currently existing between Australia's thin capitalisation legislation and double tax treaties it is a party to.

An alternative to ensuring Australia's thin capitalisation provisions are effective is to dispense with the need for such regulations. It is argued thin capitalisation provisions seek to prevent the erosion of the national tax base of a particular country.^[96] However, it is the decisions of such national taxation authorities that actually result in such erosion. That is, the erosion of the tax base comes as a result of their own legislative decisions including the following:

It is in reaction to such inconsistencies within taxation legislation that the need for, and subsequent introduction of, approaches to deter thin capitalisation practices has occurred. What is needed is a more pro-active response to thin capitalisation on a universal basis, whereby the need to implement such approaches is eliminated.

The obvious conclusion is that rather than introduce thin capitalisation legislation, it is more logical to align the taxation of dividends and interest so as to eliminate the basis for thin capitalisation. In order to achieve this tax policy objective, a number of possible alternatives could be implemented. These include the following:

Such action must be adopted on a global basis, to ensure debt financing is not redirected to those countries maintaining the comparative tax advantage of debt as opposed to equity.

The implementation of such policy options represents a logical solution to the issue of thin capitalisation, as the alignment of the taxation of interest and dividends does not discriminate between the use of either debt or equity in a corporation's capital structure from a taxation perspective.

Such a proposal assists in relieving concerns about the erosion of a country's national tax base caused by thin capitalisation practices by adopting a pro-active, as opposed to a reactive approach to the inconsistencies existent within taxation legislation.

Dean Hanlon, B Ec (Monash), M Com (Monash), CPA is a Lecturer in the Faculty of Law and Management at La Trobe University and teaches both undergraduate and postgraduate tax subjects. Prior to joining La Trobe University, Dean was an Assistant Lecturer in the Faculty of Business and Economics at Monash University.

^[1] G Telford, “Thin Capitalisation – Debt/Equity Ratios” (1989) November Taxation Practitioner 473.

^[2] OECD, Issues in International Taxation No.2: Thin Capitalisation; Taxation of Entertainers, Artists and Sportsmen (1987); D Piltz, General Report in Cahiers De Droit Fiscal International: International Aspects of Thin Capitalisation (1996) XXXIb International Fiscal Association, Geneva Congress 83 D Arnold, General Report in Cahiers De Droit Fiscal International: Deductibility of Interest and Other Financing Charges in Computing Income (1994) LXXIXa International Fiscal Association, Toronto Congress 21.

^[3] Thin capitalisation is also referred to as "hidden capitalisation", "hidden equity", or "earnings stripping".

^[5] As non-resident investors are not entitled to imputation credits, unfranked dividends may be distributed to such investors, despite the payment of company tax by resident subsidiaries, as a form of dividend streaming. This compounds the comparative advantage of debt as opposed to equity. Unfranked dividends are generally subject to a withholding tax rate of 30%, but for dividends paid to residents of countries with which Australia has a double tax treaty the rate is 15% (ITAA36, s 128B(1)). Continuing with Example 1, a withholding tax rate of 30% (15%) gives rise to a payment of $192 ($96) withholding tax. Coupled with the $360 company tax paid, profits are subject to an effective tax rate in Australia of 55.2% (45.6%).

^[6] Telford, above n 1; S Williamson, "Thin Capitalisation: A Critical Review" (1991)8(2) Australian Tax Forum 181.

^[8] Ibid; L Burns, "Introduction to Double Tax Treaties" (1990) International Tax Workshop: Current Developments in Double Tax Treaties 2.

^[9] P Baker, Double Tax Conventions and International Tax Law (2nd ed, 1994) 7; Burns, ibid 3; Piltz, above n 2, 89.

^[10] Baker, ibid 10-11; Burns, above n 8, 5; S Phillips, Tax Treaty Networks 1988-1989 (1st ed, 1990) ix; A Smith, Tax Avoidance and Non-resident Investors: The Case of Thin Capitalization (1st ed, 1992) 35.

^[14] R Krever, "Australia: Thin Capitalisation Legislation" (1990) 44(1) Bulletin for International Bureau of Fiscal Documentation 21,22.

^[16] Recommendations in the Review of Business Taxation, A Tax System Redesigned (1999) ("Ralph Report"), advocate significant changes to Australia's thin capitalisation provisions. The Australian government has supported the introduction of such recommendations as legislative provisions given they have the characteristics of "strengthening the thin capitalisation rules to prevent multinationals (both foreign and Australian based) from reducing their Australian tax by allocating a disproportionate share of debt to their Australian operations": Treasurer, Press Release No. 74, 11 November 1999.

^[17] B Lawrence, "Government Restrictions on International Corporate Finance (Thin Capitalisation)" (1990) 44(3) Bulletin for International Bureau of Fiscal Documentation 118, 119.

^[20] Persons being associates of a non-resident are deemed to exist when the link between them and the non-resident is as low as 15%(ITAA36, s 159GZC).

^[21] Recommendation 22.7 in the Ralph Report advocates raising the threshold for foreign control to 50% as this is consistent with the control test implemented in the Controlled Foreign Company ("CFC") regime. It is argued that an alignment with the CFC provisions will reduce compliance costs.

^[24] Recommendation 22.3 in Ralph Report recommends the fixed debt to equity ratio be set at 3:1 for all entities other than financial institutions. Recommendation 22.4 states that for financial institutions subject to capital adequacy rules the acceptable level of debt to equity must be in accordance with such rules. If, however, financial institutions are not subject to capital adequacy rules the specified debt to equity ratio is:

^[27] B Jackson, "International: Thin Capitalization" (1990) 44(12) European Taxation 319, 321; G Richardson, D Hanlon and L Nethercott, "Thin Capitalisation Rules: An Anglo-American Comparison" (1998) Spring International Tax Journal 37, 41.

^[28] Richardson et al, above n 27; G Richardson and D Hanlon, "Asia-Pacific - A Critical Review of the Thin Capitalization Rules" (1997) August Asia-Pacific Tax Bulletin 239, 244.

^[29] J Fairley and M Penney, "Thin capitalisation" (1988) 15(4) Tax Planning International Review 8, 10; Jackson, above n 27, 321.

^[31] Recommendation 22.1 in the Ralph Report endorses an expansion of Australia's thin capitalisation regime by applying such provisions to the total debt of the resident subsidiary corporation of a non-resident investor. As a consequence, debt financing limitations will be extended to include all third party debt, irrespective of whether it is guaranteed by a foreign controller.

^[34] Such a multiple is termed the "foreign equity product" of the company (ITAA36, s 159GZA).

^[35] Disqualified interest may also be based on the highest total foreign debt of the taxpayer at any one point in time in the year of income (ITAA36, s 159GZS).

^[36] Recommendation 22.2 in the Ralph Report advocates a two-tier approach in determining excessive interest. As an initial requirement, a resident corporation must meet an acceptable level of debt to equity (as specified in Recommendations 22.3 and 22.4). However, if the fixed debt to equity ratio is exceeded, the resident corporation may not be subject to thin capitalisation if it is able to prove that the level of debt financing could be borne by an independent party having regard to:

^[46] T Hughes and R Collier, "Thin Capitalization Following the OECD Report: A Country Survey" (1989) 16(8) Tax Planning International Review 3.

^[53] Countries including Australia, Canada, Finland, France, Germany, Indonesia, the Netherlands, New Zealand, Spain, Switzerland and the United States have implemented the fixed ratio approach.

^[61] Deloitte Touche Tohmatsu International, Thin Capitalization (1st ed, 1993) xvii.

^[70] Excessive interest payments between a resident borrowing corporation and the non-resident lender are effectively taxed at the company tax rate of 36% (ITAA36, s 159GZS).

^[77] Recommendation 22.5 in the Ralph Report advocates an extension of thin capitalisation provisions to include resident investors. That is, Australian multinational investors holding non-portfolio investments in controlled foreign entities or offshore permanent establishments are to be subject to thin capitalisation provisions on their Australian operations. It is argued Australian multinational investors are in a position to allocate excessive debt to their Australian operations to gain tax advantages. As a consequence, such investors should fall within the scope of Australia's thin capitalisation regime. In implementing such recommendations a two-tier approach is endorsed. As an initial requirement, Australian multinational investors must meet an acceptable level of debt to equity (as specified in Recommendations 22.3 and 22.4). If the fixed debt to equity ratio is exceeded, a deduction for interest is disallowed to the extent that the gearing of the Australian operations exceeds:

^[78] The Australia/United States Double Tax Convention, Art 23(2) states: "Nothing in this Article relates to any provision of the taxation laws of a Contracting State: ... (c) reasonably designed to prevent the avoidance or evasion of taxes..."

^[82] Recommendation 22.22 in the Ralph Report advocates the inclusion of a non-discrimination article in all future double tax treaties Australia is a party to. As a consequence, the inability of Australia to comply with a non-discrimination article when deterring thin capitalisation practices may be extended beyond the Australia/United States Double Tax Convention.

^[88] By endorsing a two-tier approach to deter thin capitalisation, the Ralph Report recommends the introduction of the combination approach in Australia. Recall that Recommendation 22.2 advocates the enforcement of a fixed debt to equity ratio as an initial requirement. However, by proving the level of debt financing could be borne by an independent party, a resident corporation may exceed the debt to equity ratio. This represents a combination of the fixed ratio and flexible/arm's length approaches.

^[89] D Kinneally and K Ohkawa, "Japan" (1994) Tax Developments Yearbook 44; S Sultan, "Japan Curbs Related Party Debt" (1994) July/August International Tax Review 29, 29; M Organisak, "Japanese Thin Capitalization Rules: One Year On" (1993) 20(2) Tax Planning International Review 21, 24.

^[93] J Lee and S Moller, "New Law Aims for Global Coverage" (1996) April International Tax Review 19, 22.

^[96] Lawrence, above n 17, 118; Richardson et al, above n 27, 36; Williamson, above n 6, 181.