Funding an Australian subsidiary: equity, intercompany loans and the tax limits on debt

A new Australian subsidiary usually starts with no revenue and real costs: staff, rent, software, advisers. The parent has two basic ways to fund it. It can put in equity, by subscribing for shares, or lend money under an intercompany loan. Each has different corporate, tax and director consequences. Debt from an overseas parent brings in Australia's thin capitalisation rules, the newer debt deduction creation rules, interest withholding tax and transfer pricing. This guide sets out how each works so you can brief your advisers and the subsidiary's board.

It is general information, not tax advice. The rules below are detailed and the tax effect in the parent's country matters as much as the Australian side.

Equity or debt at a glance

Many groups use a mix: enough equity to keep the subsidiary clearly solvent, and debt for specific needs. The right mix is a judgment for your advisers.

Equity: issuing shares to the parent

Equity is the simplest route. The subsidiary's board issues new shares to the parent for cash, following the constitution and any shareholder approvals required. ASIC says the company must tell it about every share issue within 28 days after the issue, and about new classes of shares within 28 days too. The mechanics, forms and register updates are in issuing or transferring shares in a Pty Ltd.

Points to settle before the first injection:

• Issue price and number of shares. Agree these with your advisers and check the constitution, since they affect the members register and any later capital return.
• Repeat injections. If the parent will fund monthly or quarterly, a standing process (board resolution, subscription letter, ASIC notice) avoids late notices.
• Getting cash back. Returning capital is usually harder than repaying a loan. Dividends, capital reductions and buy-backs each have their own Corporations Act conditions and procedures.

Dividend withholding and franking are covered in company tax obligations for foreign-owned companies.

Debt: the intercompany loan

A loan gives the parent a clear repayment right and, if interest is charged, gives the subsidiary a possible tax deduction. That deduction is why Australia limits it.

Is it really debt for tax?

Australian tax law classifies an instrument as debt or equity under Division 974 of the ITAA 1997, as explained in the ATO's guide to the debt and equity tests. The classification decides whether returns may be frankable (equity) or deductible (debt). A 'loan' with returns that depend on the subsidiary's performance may not be treated as debt. Have the loan terms reviewed against these rules.

Documentation the board should see

• a written loan agreement signed by both companies
• principal, currency, interest rate or basis, payment dates, term and repayment terms
• whether interest is paid, capitalised or accrued
• a board resolution approving the loan as being in the subsidiary's interest
• a note of how the interest rate was set (see transfer pricing below).

Thin capitalisation (from 1 July 2023)

Australia's thin capitalisation rules limit debt deductions for, among others, Australian entities that are foreign controlled. The ATO's company tax return instructions list who is affected and who is not.

The $2 million threshold

An entity is not affected by the thin capitalisation rules for an income year if its debt deductions, together with those of any associate entities, are $2 million or less. Many early-stage subsidiaries sit under this. But the test includes associates, so a subsidiary inside a larger group may not be able to rely on it.

General class investors and the three tests

For income years beginning on or after 1 July 2023, a new 'general class investor' category applies to most non-financial entities, per the ATO's entity categories page. A typical foreign-owned trading subsidiary that is over the threshold will be a general class investor. It applies one of three tests:

1. Fixed ratio test (the default). The fixed ratio test applies unless the entity chooses another test. The entity's fixed ratio earnings limit is 30% of its tax EBITDA for the year. Tax EBITDA starts from taxable income or tax loss and adds back items including net debt deductions. Net debt deductions above the limit are disallowed. Amounts disallowed under this test can be claimed as a special deduction in a later year, for amounts from the previous 15 income years, but only if the entity has continually applied the fixed ratio test.

A loss-making subsidiary has little or no tax EBITDA, so under this test its interest deductions can be largely disallowed in its early years. That is one of the most common surprises for groups that fund a start-up subsidiary with a large loan.

2. Group ratio test (elective). The group ratio test can be chosen by a member of a GR group whose group EBITDA is greater than zero. It uses the worldwide group's ratio of net third party interest expense to group EBITDA, drawn from audited consolidated or global financial statements. It can help where the whole group is highly geared with external debt.

3. Third party debt test (elective). The third party debt test allows debt deductions on qualifying debt that is issued to and held by an unrelated third party, where the lender's recourse is limited to Australian assets. Guarantees and similar credit support are generally excluded from those assets unless specified. It does not help with a loan from the parent. The choice must be made in the approved form by the earlier of the day the return is lodged or due (or a later day the Commissioner allows), and some entities are deemed to have made it.

Debt deduction creation rules (from 1 July 2024)

The debt deduction creation rules (DDCR) sit alongside thin capitalisation. The ATO's instructions say that, for income years starting on or after 1 July 2024, they disallow related-party debt deductions in two main cases:

• Acquisition case. Debt deductions may be disallowed where the entity acquires a CGT asset or a legal or equitable obligation from an associate pair, with exceptions such as new membership interests, certain new depreciating tangible assets used in Australia within 12 months, and new debt interests issued by an associate pair.
• Payment or distribution case. Debt deductions may be disallowed where the entity uses a financial arrangement to fund, or facilitate funding of, certain payments or distributions to an associate pair.

Two features catch people out:

• The rules apply to arrangements entered into before 1 July 2024 where debt deductions continue to arise, not just new ones.
• The DDCR can apply even where an entity meets the asset threshold exemption from thin capitalisation. The $2 million debt deduction exemption still applies to the DDCR.

In practice, borrowing from the parent to pay the parent (for example, to buy an asset from it or fund a dividend) needs specific advice.

Interest withholding tax

Interest the subsidiary pays to a foreign parent is subject to withholding. The ATO's withholding rate page says the rate is 10% for interest payments. A lower rate applies if the payment is made to a resident of a country with a tax treaty with Australia and the treaty specifies a lower rate. Check the parent's treaty, and whether the parent actually qualifies under it, before the first payment. The subsidiary is the one that has to withhold and pay the amount to the ATO, so the board should know the loan is in place and how interest is being handled.

Transfer pricing of the loan

The interest rate and terms of a cross-border related-party loan must be consistent with arm's length conditions under Australia's transfer pricing rules. The ATO's compliance approach is in PCG 2017/4, which has applied since 1 July 2017 to existing and new arrangements with non-resident related parties. It sets out a risk assessment framework with risk zones, and says falling outside the low risk zone does not mean the arrangement is uncommercial, only that it is more likely to attract attention. How the subsidiary documents its pricing generally is covered in transfer pricing for an Australian subsidiary.

Solvency, guarantees and letters of support

The subsidiary's directors must not let it incur debts while insolvent, and a parent loan repayable on demand is a debt. Two tools are common:

• Subordination or deferral. The parent agrees not to call the loan, or to rank behind other creditors, for a period. This can make a balance sheet more workable, but it has to be documented and binding to help.
• Letter of support. The parent states it will provide financial support so the subsidiary can pay its debts. These range from comfort letters with no legal force to binding undertakings. Directors relying on one should check what it actually commits the parent to, for how long, and whether the parent can pay.

A letter of support doesn't replace the board's own judgment. The directors still need to form a view that the subsidiary can pay its debts as they fall due, for example at the annual solvency resolution. If the subsidiary is in difficulty, read insolvent trading and safe harbour and get advice early.

A funding checklist for the board

1. Agree the funding plan for the first 12 to 24 months with the parent.
2. Get tax advice in both countries on equity, debt or a mix.
3. For equity: issue shares properly and lodge the ASIC notice within 28 days.
4. For debt: sign a loan agreement, minute the board's approval and document the interest rate basis.
5. Check thin capitalisation (including the $2 million associate-inclusive threshold) and the DDCR.
6. Set up interest withholding at the correct rate before interest is paid.
7. If relying on parent support, get a written letter and review it at least annually.

A resident director is a member of the subsidiary's board and will need to see these documents. We provide resident directors and company secretarial support, including board resolutions and ASIC share notices; we don't give tax advice. See our pricing or start here.

General information about Australian law and practice, not legal or tax advice for your circumstances. Check the official sources, or ask your adviser, before you act.