It’s important in this exercise to remember that, although the denial of interest deductions under the thin capitalisation regime is to a company’s disadvantage, simply refinancing with equity is not necessarily an automatic response. Replacing debt that has deductions denied under the thin cap rules with non-deductible equity will not reduce your Australian corporate tax liability.
But it’s not that simple. Withholding tax differences between debt (10 percent) and equity (0 percent if franked) are relevant, as is the availability of a credit for the Australian tax payable (direct and/or underlying) in the home jurisdiction. Replacing debt (particularly shareholder debt) with equity will make it more problematic to return surplus funds in the future – beware of Section 45B!
Ultimately, a denial of interest under the thin capitalisation rules maximises an entity’s deductible Australian debt under the safe harbour rules – all other things being equal.
The other 'wild card' is the interaction with the new Section 25-90 denial of interest deductions on debt used to finance offshore operations. If these provisions apply, a tracing exercise is required. Any refinancing should be carefully considered and implemented to ensure that the 'right' debt is refinanced. In particular if these provisions are potentially triggered, we are recommending clients perform a debt deduction due diligence exercise.
So, as you explore the different options available to improve your thin capitalisation position, the options pursued need to make commercial sense, and consider not just the Australian tax implications that will arise.