Thin capitalisation 101: does Div 820 apply to you?

Inward investing financial entities (non-ADI)

An inward investing financial entity (non-ADI) that is not also an outward investing financial entity (non-ADI) can choose to apply the third party debt test, in which case all or part of its debt deductions for the income year may be disallowed. The amount of debt deductions disallowed is the amount by which debt deductions exceed the entity’s third party earnings limit (see above).

If the entity does not choose the third party debt test and its “adjusted average debt” exceeds its “maximum allowable debt”, then all or a part of each debt deduction of the entity may be disallowed. The maximum allowable debt is the greater of the “safe harbour debt amount” or, if applicable, the “worldwide gearing debt amount”. The actual amount of the deduction disallowed is calculated under s 820-220.

Under the safe harbour debt test, the amount of debt used to finance the Australian investments is considered excessive when it is greater than that permitted by the safe harbour gearing limit of 1.5:1 with respect to an entity’s non-lending business. An on-lending rule operates to exclude any debt that is on-lent to third parties or used for similar financing activities. The application of this on-lending rule is limited by an additional safe harbour gearing ratio of 15:1 which applies to the entity’s total business. There are also special rules that result in higher allowable gearing ratios for entities that have assets which are allowed to be fully debt funded.

The worldwide gearing debt test does not apply to an inward investing financial entity (non-ADI) if its statement worldwide equity or assets (as defined) is nil or negative, or if audited consolidated financial statements do not exist. The calculation of the worldwide gearing test amount depends on the type of entity involved (ss 820-217 to 820-219; Subdiv 820-JA).

Outward investing financial entities (non-ADI)

Similarly, an outward investing financial entity (non-ADI) can choose to apply the third party debt test, in which case all or part of its debt deductions for the income year (to the extent that they are not attributable to its overseas permanent establishments) may be disallowed. Again, the amount of debt deductions disallowed is the amount by which debt deductions exceed the entity’s third party earnings limit (see above).

If the entity has not chosen the third party debt test and its “adjusted average debt” exceeds its “maximum allowable debt”, then all or a part of each debt deduction of the entity for the income year (to the extent that they are not attributable to its overseas permanent establishments) may be disallowed. The maximum allowable debt is the greater of the “safe harbour debt amount” and, if applicable, the “worldwide gearing debt amount”. The actual amount of the deduction disallowed is calculated under s 820-115.

The safe harbour limit is fundamentally the same as that described for inward investing financial entities (non-ADI). The limit takes account, however, of the amount and form of investment in the Australian non-ADI’s controlled foreign investments.

The worldwide gearing debt test for outward investing financial entities (non-ADI) allows an Australian entity with foreign investments to fund its Australian investments with gearing of up to 100% of the gearing of the worldwide group that it controls. However, this test is not available if the Australian entity is itself controlled by foreign entities.

Inward investing ADIs

An ADI’s debt deductions will be reduced where the equity capital used to fund the Australian operations is less than a minimum equity requirement.

The minimum amount of equity capital for an inward investing ADIs (ie foreign ADIs with Australian permanent establishments) is the lesser of:

• the safe harbour capital amount, ie 6% of Australian risk-weighted assets, and
• the arm’s length capital amount, ie a notional amount that represents what would reasonably be expected to have been the entity’s minimum arm’s length capital funding of its Australian business throughout the year.

Outward investing ADIs

Outward investing ADIs (ie Australian ADI entities with foreign investments) have the same requirement, but must also have capital to match certain other Australian assets. The minimum amount of equity capital for outward investing ADIs is the lesser of:

• the safe harbour capital amount
• a notional arm’s length capital amount, and
• the worldwide capital amount. This allows an Australian ADI with foreign investments to fund its Australian investments with a minimum capital ratio equal to 100% of the Tier 1 capital ratio of its worldwide group.

Debt deduction creation rules

Besides the above tests that aim to limit the amount of debt deductions that entities can claim, additional debt deduction creation rules (or DDCRs) operate to bolster anti-avoidance provisions. Broadly speaking, the DDCRs in Subdiv 820-EAA aim to disallow deductions to the extent they are incurred in relation to debt creation schemes that lack genuine commercial justification. They apply to general class investors and non-ADI financial entities.

Div 820 significantly reformed in 2024

Division 820 as described above has been significantly reformed by Act No 23 of 2024. Interestingly, the changes in that Act do not apply to “Australian plantation forestry entities”, ie entities that solely or predominantly carry on a business of establishing and tending trees for felling in Australia (i146 of sch 2 to Act No 23 of 2024). For these specific entities, the old law in force immediately before the amendments in Act No 23 of 2024 on 1 July 2024 continues to apply.