Essentially, section 25-90 (and its TOFA equivalent provision) allows a tax deduction for borrowed funds used to finance a non-portfolio investment in a foreign subsidiary generating exempt foreign dividend income. The borrowed funds, whether from a related or third party, is generally subject to a debt to equity ratio limit of 3:1under Australia's thin capitalisation rules.
What was the original policy of Section 25-90? Prior to Section 25-90, interest deductibility for outward investors was determined by section 8-1 of the ITAA 97 and the old foreign loss quarantining provisions. Interest expense was non-deductible where it is incurred in deriving exempt income. Establishing deductibility of interest required funds to be traced. Introducing Section 25-90 obviated the need to trace the use of funds and thus, it was seen as a compliance cost saving measure. The thin capitalisation rules applied to all debt (not only foreign related part debt) thereby maintaining a level of integrity in its operation.
But the policy behind Section 25-90 went beyond a compliance cost saving measure. Tracing the use of funds meant it was "relatively easy to circumvent" the general deductibility and foreign loss quarantining provisions "by establishing a use of funds that ensures deductibility", according to the EM to the thin capitalisation Bill in 2001. The EM went on to say it is possible to circumvent the general provisions by using interposed entities to separate the foreign income from expenditure. Will the repeal of Section 25-90 resurrect the original integrity concerns?