While this represents an exciting milestone, it’s also a phase that demands careful tax planning. To reduce the risk of a potential loss of significant capital, it’s critical to have the right structure in place for your transition.
A primary hallmark of the transition into development is the need for substantial funding. That’s why you need to ensure you’re across these six essential tax considerations for structuring your funding:
1. Debt-to-equity funding mix
Equity is the primary funding mechanism during the exploration phase, which remains a crucial funding device during development phase. However, when entering development and deeming a project to be economically feasible, a company gains greater access to the debt lending market.
There will often be an appeal to debt fund from a tax perspective, due to the deductibility of interest payments, and the non-deductibility of equity distributions (e.g. dividends). However, there are circumstances where interest payments may be non-deductible or come with additional costs. These are discussed below.
2. Key loan agreement terms – is debt really debt?
For interest deductions to be allowable, the financing must meet specific tax definitions of ‘debt’. Situations may arise where what is legally considered debt does not align with tax definitions, rendering the interest payments non-deductible. Consideration must be applied to key terms of the loan, including the contingency of repayments, maturity of the loan, and interest rates.
3. Thin capitalisation – capping deductible interest amounts
For companies that form part of an international group, the thin capitalisation rules limit the amount of debt than can be claimed based on prescribed caps. These rules are in the process of being amended, with the default method now capping interest deductions using an EBITDA metric, as opposed to a balance sheet metric. Companies that are part of an international group should understand their interest deduction capacity prior to determining the debt component of their funding.
4. Lender location – to withhold or not withhold
The location of a lender introduces additional tax considerations, with the most obvious being the prospect of paying withholding tax where the lender is foreign. This not only applies to cross border payments of interest, but also to unfranked dividend and natural resource income payments. It’s important to identify if a withholding tax gross-up clause exists in the funding agreement as this can have a direct increase in the cost of funding.
As noted above, although there is an increased capacity to partially debt fund a project in the development phase, there is still generally a sizable equity component. Some critical considerations from a tax perspective of equity funding include:
5. Mix and spread of new equity investors
Raising funds through equity generally coincides with the issuance of new shares.
Exploration companies often accumulate significant tax losses. Tax losses can be carried forward indefinitely and used to offset future taxable profits, provided either the Continuity of Ownership Test (COT) or, failing the COT, the Business Continuity Test (BCT) is satisfied. This becomes important once a mining company becomes profitable through the development phase into production.
The COT is an objective test that evaluates whether the majority (more than 50 per cent) of the ultimate beneficial ownership of the company has remained the same, from the start of the income year that the losses were incurred, to when the losses are to be used. Therefore, where the raising of project finance is executed partially or wholly via shares, an analysis of the mix and spread of shareholders should be examined to determine the ramifications it has on the company’s ability to satisfy the COT and maintain its tax losses.
Highly concessionary rules apply to stock exchange listed and widely held companies. Therefore, it’s not always intuitive when COT has been passed or failed.
Where the COT is failed, tax losses may still be used in future income years, however only where the company satisfies the BCT. This test is more subjective and examines the underlying nature of the company from the time the COT was failed, until the time in which the tax losses are being utilised. Due to the subjective nature of the test, it tends to attract higher ATO scrutiny.
6. Level at which the equity is being injected in an Australian wholly owned group
Injecting equity through the issuance of shares at the subsidiary project-company level may have negative tax consequences where the subsidiary is part of a tax consolidated group. This action may trigger a capital gains tax event through the subsidiary member exiting the tax consolidated group. Additionally, the tax losses that the subsidiary accumulated during its exploration phase are retained by the head entity of the tax consolidated group. Consequently, these losses cannot be used to offset future profits of the income generating subsidiary once it exits the tax consolidated group
There are circumstances where the implications of injecting capital at the subsidiary level are not detrimental, however, the consequences of the level at which the equity is injected should be analysed prior to the execution of the agreement.
Whilst commercial drivers for companies transitioning into development should have primacy, tax should be more than an afterthought.
To ensure your funding structure does not cause unwanted tax costs our tax team can assist you with your transition into development. Please don’t hesitate to reach out for further guidance on the considerations highlighted in this article.
