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Are there limits to interest deductions in Australia in participative loan arrangements involving entities in the same economic group?

Question on taxlinked.net members forum about Participative Loan Taxation

Since 1st January 2015 in Spain, interests are (interest is) not tax deductible when the participative loan is agreed to between entities of the same economic group. Is there similar treatment in your countries?

Response to post

Generally not in Australia.

In Australia interest is deductible if incurred on debt finance obtained to earn assessable income or to carry on a business even if debt finance arrangements include entities not dealing with each other at arms length.

These deductibility tests are serious purposive tests so non-arms length transactions attract particular scrutiny and, like in most jurisdictions, the burden of making out either purpose is on the taxpayer. As well as the general construct of sham there are a numerous specific instances where the Australian law denies interest deductions including:

  • sometimes where deductions are prepaid;
  • where there is not a sufficient relation between the loan and income received after a “commonsense” or “practical” weighing of the circumstances; and
  • where deductions are artificial or contrived or have those elements– if specific anti-avoidance rules do not apply.

Australia has a longstanding general anti-avoidance provision that can apply even if the interest deduction was otherwise available under the law. In international outbound financing the deduction can be lost because foreign income can be treated as other than assessable income. International debt/hybrid mismatch rules are being developed in Australia following some taxpayer success resisting anti-avoidance rules and the international experience.

Deductions are also lost if a “loan” is technically found to have characteristics of equity in substance.

Australian courts look at the role of associated entities to understand their purpose and look at transactions holistically. In other words they will focus on the economic units, rather than on juristic entities which seems to happening in Spain from what you say. Hence an interest deduction to an entity can be reduced, for instance, if the debt finance is on-lent to a related entity to earn income palpably less than the deduction.

Australia also has thin capitalisation rules which apply to limit otherwise allowable large cross border interest deductions.

Chevron Australia is involved in the first major transfer pricing case under the new BEPS regime where the Commissioner of Taxation is fighting to contend that interest paid and deducted exceeded the arms length amount based on BEPS arms length principles. The Commissioner won the first stage of the case in 2015.