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WHAT IS THIN CAPITALISATION AND WHAT RULES DOES IT FOLLO

24
May

A company is naturally financed through a blend of debt and equity. Thin capitalisation refers to the condition in which a company is financed through a relatively elevated level of debt compared to equity. A thinly capitalised entity is one whose debt is much greater than its equity capital; at times this relationship is expressed as a ratio. For example, a ratio of 1.5:1 means that for every $2 of equity the entity has $3 of debt. Thinly capitalised companies are sometimes referred to as highly leveraged. The way a company is capitalised will frequently have a substantial impact on the amount of profit it reports for tax purposes. The higher the level of debt in a company, the lower will be its taxable profit. Therefore, debt is often a more tax efficient way of finance than equity.

Thin Capitalisation Rules
Debt amount is constrained when used to fund the Australian operations of both foreign entities investing into Australia and Australian entities investing overseas under the thin capitalisation rules. The thin capitalised rules prohibit a deduction for a proportion of specified expenses an entity incurs in relation to its debt deductions. When the entity's debt-to-equity ratio surpasses specific limits then thin capitalisation rules applies. A debt deduction is an expense an entity incurs about a debt interest. Certain expenses are omitted from being debt deductions under tax law.
Entities consisting of business in both Australia and overseas, the thin capitalisation rules affect them. These are the following entities:
 

Outward investing entities: Australian entities with specified overseas investments;
Inward investing entities: Foreign entities with certain investments in Australia, nevertheless of whether they hold the investments directly or through Australian entities.

If an individual satisfies one of the subsequent tests, then he/she will not be affected by the thin capitalisation rules:

• You are an Australian resident entity that is neither an inward investing entity nor an outward investing entity. 
• You are an overseas entity that has no reserves or investments in Australia.
• You meet any of the three threshold tests: 

1. Your debt deductions jointly with any associate entities are $2 million or less for the    income year.
2. You are an outward investing entity that is not also overseas controlled and you meet the assets threshold test;
3. You are a special purpose entity recognised to manage certain risks.