Dealing With the Changes to the Thin Capitalisation Rules. Reprinted with permissions from Business Valuation Resources, LLC

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1 TIMELY NEWS, ANALYSIS, AND RESOURCES FOR DEFENSIBLE VALUATIONS Vol. 1, No. 1, July 2014, 3 Qtr. BUSINESS VALUATION AUSTRALIA Dealing With the Changes to the Thin Capitalisation Rules By John-Henry Eversgerd and Joanne Dunne On 8 May this year, the federal government issued exposure draft legislation proposing changes to the thin capitalisation rules. When passed, these changes can result in higher taxes for multinationals if not managed appropriately. These changes have been well signalled, with the previous Labor government first announcing proposed changes in May 2013 in the 2013/2014 budget, and, following a change of government, the current federal government confirmed in November 2013 that it would be proceeding to legislate the changes previously proposed. In this article, we summarise the current thin capitalisation rules and the proposed changes. We then briefly touch on the impact of the changes before turning to consider a solution where adverse impacts arise. We focus on the revaluation of assets, including intangible assets, as a practical step that affected entities can take to manage the impact of the proposed changes. The thin capitalisation rules current rules and proposed changes. The policy intent of the thin capitalisation rules is to prevent the allocation of excessive debt deductions to Australia, as compared to other jurisdictions. The thin capitalisation rules apply to both inward and outward investment, that is, to entities that are either: Foreign-controlled Australian entities; Australian entities that control a foreign entity or operate from a permanent establishment (such as a branch) in a foreign jurisdiction; or Foreign entities carrying on business in Australia. Debt deductions are not subject to the thin capitalisation rules where they are in aggregate below a de minimis threshold currently AUD$250,000, but that is proposed to increase to AUD$2 million. The thin capitalisation rules are designed to limit available deductions on debt, where the debt levels exceed prescribed maximum debt thresholds. Those thresholds were designed to provide for what is considered to be appropriate gearing. A taxpayer can choose which threshold to apply each financial year. The thresholds are set out in Exhibit 1. Some slightly different threshold tests, also set out in Exhibit 1, apply to authorised deposittaking institutions (ADIs) such as banks and to particular financial institutions that are not themselves ADIs. These tests are broadly based on prudential regulatory requirements and are designed to ensure there is a minimum level of equity capital. The Board of Taxation has also been tasked with a review of the debt/equity rules in Division 974 of the Income Tax Assessment Act 1997 (Cth). Amongst other matters, the debt/equity rules identify what is debt for the purposes of the thin capitalisation rules.

2 BUSINESS VALUATION AUSTRALIA Managing Editor: Publisher: Production Editor: Desktop Editor: Customer Service: VP of Sales: President: CEO: John-Henry Eversgerd Sarah Andersen Janice Prescott Monique Nijhout Retta Dodge Lexie Gross Lucretia Lyons David Foster EDITORIAL ADVISORY BOARD SIMON DALGARNO LEADENHALL CORPORATE ADVISORY ADELAIDE, SA JOHN E GIBSON CBV FCA Business Valuation Australia (ISSN pending) is published quarterly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR U.S.A. The annual subscription price for the Business Valuation Australia is $419. Low-cost site licenses are available for those who wish to distribute the BVA to their colleagues at the same firm. Contact our sales department for details. Please contact us via at customerservice@bvresources.com, phone at , fax at or visit our website at BVResources.com/Australia. Editorial and subscription requests may be made via , mail, fax or phone. Please note that by submitting material to BVA, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2014, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR. ABOUT About BVR BRENDAN P. HALLIGAN HALLIGAN & CO IAN JEDLIN KPMG AUSTRALIA RICHARD STEWART PRICEWATERHOUSECOOPERS Business Valuation Resources is pleased to offer premier products and services to the business valuation profession around the globe. Top business valuation firms depend on BVR for authoritative market data, continuing professional education, and expert opinion. BVR is your one-stop shop for newsletters, merger and acquisition data, guides and books, research reports, continuing education, and more. We are delighted to announce the launch of BVR Down Under! We have partnered with a network of business valuation practitioners, writers, and associations in Australia to deliver news, training, and resources to anyone in need of Australian-specific business valuation content. As a part of the initial stages of its review of those rules, the Board of Taxation issued a discussion paper in March If the Board of Taxation recommends changes in its final paper (which is due by March 2015), those proposals may also impact on the thin capitalisation rules. The impact of the proposed changes. Affected entities need to consider the impact of the proposed changes on their funding levels, tax debt deductions, and balance sheet and take advice for adjustments where necessary. In particular: The reduction of the general safe harbour from 3:1 to 1.5:1 means that affected entities will need to investigate the alternatives (the worldwide gearing test and arm s-length test) more closely. The changes impacting on ADIs/banks are likely to have lesser impact, as affected organisations have been compliant with Basel III since January 2013 in any event. The changes will particularly impact resources and infrastructure entities that generally carry a large level of debt funding. Those entities will need to consider their balance sheets, consider asset revaluations, and may need to restructure current financing arrangements (which will, of course, itself give rise to tax issues). Foreign investors in resource and infrastructure projects will expect a particular level of return that may be affected by the impact of these changes on the balance sheet. The proposed changes will also potentially impact on the ability to attract new foreign investment in resource and infrastructure projects and the cost of such funding. Although having foreign-controlled investors in a project could cause the project to be subject to thin capitalisation rules, having domestic outbound investors in a project may equally trigger the debt limits 2 Business Valuation Australia July 2014, 3 Qtr.

3 Tax deductions for interest based on Safe harbour debt test (nonfinancial entities, non-adis) Safe harbour debt test for financial entities (non-adis) Safe harbour minimum capital test for ADIs Worldwide debt test for entities other than ADIs broadly the maximum level of debt is the worldwide gearing (debt-to-equity ) applied to the total value of assets, as determined under Australian accounting standards Worldwide capital test for ADIs Arm s-length debt test for non-adis Exhibit 1. Thresholds for Debt Levels How the deductible debt limit is set based on current rules Currently requires debt to be no more than 75% of the total value of assets as determined under Australian accounting standards or a 3:1 debt-to-equity Currently requires a 20:1 debt-toequity Currently requires a 4% capital-to- Australian risk-weighted assets Currently applicable only to outbound investment (i.e., Australian entities investing outside of Australia) Currently requires debt gearing in Australia equal to or less than 120% of the group s global gearing Currently provides that an entity s Australian opens must be capitalised to 80% of the capital of the Australian entity s worldwide group Broadly, the maximum level of debt is a notional amount of debt capital that would have been lent by a commercial institution in respect of Australian opens, making some assumptions (for example, that guarantees or credit support must be assumed to have not been received) and having regard to specified factors (such as general industry practice for the particular industry at issue). Proposed change To be amended to provide that debt can be no more than 60% of the total value of assets as determined under Australian accounting standards or a 1.5:1 debt-toequity To be amended to a 15:1 debt-to-equity To be amended to a 6% capital-to- Australian risk-weighted assets this reflects Basel III changes to Tier 1 capital To be extended to cover both inbound and outbound investment To be amended to require debt gearing in Australia to be equal to or less than 100% of the group s global gearing (for inward investing entities, this is to be considered using the consolidated financial statements that the foreign parent is already required to prepare) To be amended to provide that an entity s Australian opens must be capitalised to 100% of the capital of the Australian entity s worldwide group There are no current changes proposed. But the Board of Taxation has issued a discussion paper considering the test, and a final paper from the Board with its recommendations is due by December The Board of Taxation is considering a range of issues including potentially: Whether to remove or amend the annual testing requirement; Considering the factual assumptions in determining the arm s-length debt test to ensure it is prospective as opposed to retrospective in approach; Whether there should be additional safe harbour s in the test such as a test that applies a of net interest expense to pretax earnings; Whether the arm s-length debt test could be simplified where there is no related party debt; Whether credit support and guarantees should be taken into account; and Whether advanced thin capitalisation agreements could be agreed with the ATO. Date proposed change intended to be effective No current changes proposed. The Board of Taxation s recommendations are due by December July 2014, 3 Qtr. 3

4 Exhibit 2. Intangible Assets Impact on Rebel Group Source: Super Retail Group 2013 annual report (so these limitations are not purely a question of the source of funding). The changes will also affect highly leveraged mergers and acquisitions, which may therefore require revaluation (subject to when the acquisition took place) and refinancing. The arm s-length debt test is of assistance, but uncertainty is injected into the scope of that test because of the review by the Board of Taxation. That uncertainty is compounded by the review of the debt/equity rules by the Board of Taxation, which could also potentially impact on the thin capitalisation regime. Recommendations on both reviews are awaited. Asset revaluation as a solution. The Tax Laws Amendment (2008 Measures No. 5) Act 2008 revised the thin capitalisation rules to, among other things, allow companies to include the value of intangible assets in their safe harbour debt amount even if those assets are not presently recognised on the company s sheet. 1 1 The change corrected the favourable treatment previously enjoyed by companies that grow their balance sheets through acquisition versus those that To illustrate the potential for growth in assets used in the safe harbour calculation, let s take a look at the enormous growth of Rebel Group Ltd s 2 balance sheet when it was acquired by Super Retail Group Ltd (owner of Super Cheap Auto) predominantly as a result of valuing intangible assets. As can be seen in Exhibit 2, the addition of intangible assets can significantly increase the size of a balance sheet. Based on management s initial estimates, Rebel s intangibles more than double the asset balance, with approximately $250 million allocated to brands and software versus only $158 million allocated to cash, inventory, plant and equipment, and other tangible and financial assets. 3 grow organically because the accounting standards typically only allow recognition of intangible assets following a business combination. Allowing the recognition of internally generated intangible assets for thin cap calculations was a positive outcome for taxpayers since most companies have intangible assets (e.g., brands, intellectual property, customer contracts, and relationships) that can now be used to increase the safe harbour debt amount regardless of whether those intangible assets were developed internally or acquired. 2 Rebel Group Limited was the head company for Rebel Sports, the premier Australian sports retailer. 3 Details regarding companies thin capitalisation calculations are not publicly available to use as an illustn. Since the thin capitalisation recognition criteria generally follow the accounting treatment under Australian accounting standards, it is useful to 4 Business Valuation Australia July 2014, 3 Qtr.

5 Relating this example to the safe harbour debt amount, intangibles that double the balance sheet would effectively double the debt threshold that can qualify for tax deductions. While the size and type of intangible assets differ for each company and industry, it can generally be expected that most companies have intangible assets whether or not they appear in the company s financial statements. Some examples of the types of assets that can be included in safe harbour debt calculations are listed in Australia s accounting standards, including those presented in Exhibit 3. Requirements for thin capitalisation valuations. The tax law states that professionals with expertise in valuing the specific type of asset should perform all valuations for thin capitalisation purposes. This is not surprising since the analysis can be complex and support for assumptions is challenging to find. In some cases, preferred valuation methodologies have been tested over the years in courtrooms or have been reviewed by ASIC and the ATO. In many cases, the best methodology depends on the characteristics of the company or of the look at the intangible assets recognised to meet the AASB3 Business Combination reporting requirements for the acquisition of Rebel Group Limited. Exhibit 3. Examples of Identifiable Intangible Assets Customer-related intangibles Technology-based intangibles Legal or contract-based intangibles Customer lists Patented and unpatented technologies Licensing, royalty agreements Order or production backlog Software Leasing agreements Customer contracts Databases Broadcasting rights Customer relationships Secret formulas, processes Permits Distribution network Research and development Supply contracts Broker/agent relationships Take or pay agreements Maintenance and service contracts Artistic-related intangibles Government licenses Fund management agreements Plays Mining permits Business in-force Books Explon tenements Pictures Mineral reserves Marketing-related intangibles Musical works Water rights Brands Videos Port access rights Trade marks Audio visual material Landfill space Internet domain names Copyrights Liquor and gaming licenses Noncompetition agreements Newspaper mastheads particular asset. The tax law, in order to limit the risk of biased valuation outcomes, states that an independent expert is required to review any internal thin capitalisation valuations even if the company has internal experts who will perform the valuation analysis. Conclusion. Many inbound and outbound investors subject to Australia s thin capitalisation rules are expected to face reduced tax deductibility of interest for their Australian debt due to the proposed tightening of the law. An increased number of companies are availing themselves of the allowance to include the value of off balance sheet assets in their safe harbour debt calculations. Although the thin capitalisation rules will translate into larger tax bills for those breaching the current limits or the proposed lower limits, planning ahead and valuing intangible assets for thin capitalisation purposes has the potential to dramatically increase safe harbour debt amounts and qualifying interest deductions. John-Henry Eversgerd is partner at McGrathNicol and can be reached at jeversgerd@ mcgrathnicol.com. Joanne Dunne is partner at Minter Ellison and can be reached at Joanne. Dunne@minterellison.com. July 2014, 3 Qtr. 5