Advocacy Multinational Tax Integrity - Thin Capitalisation

Appendix A – Examples Example 1 – Operation of section 705-60 and 705-112 Head Co establishes a subsidiary (Sub Co) with $1,000 of share capital. Sub Co uses the $1,000 in addition to borrowing $15,000 to fund working capital in its business.

Sub Co makes $10,000 in net operating income from carrying on its business and incurs $4,000 of interest expenses. Sub Co repays the working capital loan in full.

Under the FRT method, Sub Co is denied $1,000 of deductions in relation to its interest expenses (i.e. tax EBITDA is $10,000, the FRT limit is $3,000 with $1,000 of the $4,000 of interest incurred disallowed as deductions). Sub Co has $7,000 of taxable income and a tax liability of $2,100.

Sub Co’s assets consist of $4,900 of cash. This is the $1,000 of cash funded by share capital and a further $3,900 of retained earnings being: $10,000 of net operating income less $4,000 interest expense less $2,100 income tax paid. $3,900 total retained earnings Head Co chooses to form a tax consolidated group with Sub Co, resulting in the transfer in of $1,000 of FRT disallowed amounts.

Head Co’s ACA in Sub Co will be: $1,000 cost base in Sub Co’s shares (step 1) $3,900 taxed profits accruing to the joined group (step 3) ($300) FRT disallowed amount x corporate tax rate (step 6A) $4,600 Total Under the tax cost setting rules, $4,900 is allocated to retained cost base assets result in a $300 capital gain under CGT event L3 as a result of the tax cost setting amount for retained cost base assets exceeding the ACA of Sub Co. Effectively, this results in Sub Co being taxed twice on the $1,000 of disallowed debt deductions and is inconsistent with the object of the tax cost setting rules as set out in section 70510 as the cost of acquiring the $4,900 of underlying cash should be $4,900 rather than $4,600. An appropriate outcome would occur if the Step 3 amount is not reduced by expenses that are otherwise taken into account under another step. In this case, this is the $300 additional income tax expense (that reduces retained earnings) in respect of the $1,000 FRT disallowed amounts. An anti-duplication rule is required to remove this double counting.