COVID-19 has had a significant impact on the Australian economy. However, some commercial measures that may be undertaken to relieve financial distress can result in adverse and unexpected tax consequences. This article highlights some of the tax consequences that should be considered and worked through when contemplating funding options.
In this challenging economic environment, businesses are considering their funding requirements, be that managing their existing cash position, finding cash for acquisition opportunities that might appear, taking advantage of the Instant Asset Write-off provisions announced in the Federal Budget on 6 October 2020 or to support distressed subsidiaries.
If a company needs an injection of cash to get it through this challenging period, there are a few ways of obtaining that funding, most commonly through either a loan (bank or related party) or by way of equity.
The last thing you want to do is create unintended tax consequences when implementing commercial measures to remedy financial distress.
Equity
The company wants to raise capital, why would issuing equity cause a tax issue?
The first issue arises, from a tax perspective, if the group/company has tax losses that are being carried forward from prior years. Your ability to utilise carried forward tax losses to reduce a future taxable profit relies on satisfaction of the Continuity of Ownership Test (COT) or failing that, the Same Business Test (SBT). Issuing new equity to new investors as well as existing investors (in certain circumstances) could have an adverse effect on the ability to satisfy the COT.
The key take-away is that if there is to be a capital raise or an acquisition funded via script rather than cash, and the group has carried forward losses, tax advice should be obtained prior to the issue of capital.  There is the potential to pass COT as the issue of certain debt interests and secondary share classes may be ignored from a COT perspective.
Even if the company does not have tax losses carried forward, the COT rules can impact on the ability to claim a deduction, in particular bad debt deductions.
There are a number of reasons you may wish to obtain funding directly into a subsidiary rather than at the head company level. The main concern from a tax perspective is that the issue of shares that are tax equity would ordinarily result in a deconsolidation of the subsidiary from the tax consolidated group. If the funds raised were not from the issue of shares but rather the issue of a convertible note for example, depending on the terms of the note, this may not lead to the deconsolidation of the tax group.
Debt
Not only do you need to be mindful of new debt, you also need to be cognisant of the impact that a weakened balance sheet (as a result of COVID-19) and the recession, may have on your existing debt and the ability to claim tax deductions on the interest if the Thin Capitalisation rules apply to the group.
For example, the group may have experienced write downs in the accounting value of its assets. These impairments reduce the thin capitalisation safe harbour capacity of the group. In other words, the reduction in the accounting asset base would then put pressure on the deductibility of interest and other debt costs on existing debt.
This is further exacerbated by the restrictions on revaluations for thin capitalisation which came into effect last year and it forces taxpayers to rely on asset, liability and equity balances in financial statements only.
If satisfying the Safe Harbour test is problematic, you either accept the disallowance of some or all of the interest deductions or you rely on the arm’s length debt test (ALDT).
It is anticipated that the number of taxpayers relying on ALDT will increase significantly in the current environment. The ATO published two guidance products in respect of ALDT on 12 August 2020. TR 2020/4 Income tax: Thin Capitalisation ‚Äì the arm’s length debt test, and PCG 2002/7 ‚Äì ATO compliance approach.
Interest free loans
It is common to see interest free loans within a group particularly where there is some financial distress.¬† From a tax perspective, interest free loans can be quite complex and problematic and have flow on effects causing other tax issues. Things such as, is the interest free loan equity for tax purposes, is it arm’s length, is it a capital injection which could impact on the losses, could the injection of funds cause a value shift, and/or could a transfer pricing issue arise?
The ATO is considering interest free loans provided by Australian taxpayers to non-residents in Draft Schedule 3 to PCG 2017/4. It does not consider inbound loans, however you would expect them to be lower risk given no deductions for interest are being claimed in Australia. Even so, Transfer Pricing, Withholding Tax and Value Shifting could be of concern.
Regardless of the funding option you choose to stay afloat or provide assistance over the next few months, which many believe will see the greatest economic impact since the pandemic began, you’ll need to consider whether this option is tax-effective and how to mitigate potential consequences. For more information, contact William Buck.
