It is expected the Budget will increase duties on tobacco and this will have support from all parties. So too will the adjustment to the ‘thin capitalisation’ rules that govern international companies operating in Australia. The restriction on these tax deductible interest payments, however is glaringly inconsistent with the Government’s view of tax deductibility of interest payments that flow to negatively geared property investors.
Thin capitalisation (i.e. excessive gearing) is used by both international companies and investors alike to lower assessable income in Australia.  It is just that ‘thin capitalisation’ is seldom used to describe negatively geared property investment – but it should be!
To understand the concept and the reasoning behind the Government’s concern with thin capitalisation, we have extracted the following explanation from the Australian Taxation Office website. A reader could be mistaken for thinking it describes negative gearing.
Thinly capitalised entity
A thinly capitalised entity is one whose assets are funded by a high level of debt and relatively little equity. An entity’s debt-to-equity funding is sometimes expressed as a ratio. For example, a ratio of 1.5:1 means that for every $3 of debt, the entity is funded by $2 of equity. This is also known as ‘gearing’. An entity that is highly geared funds its assets with proportionately more debt than equity.
Thin capitalisation rules
Under the thin capitalisation rules, the amount of debt used to fund the Australian operations of both foreign entities investing into Australia and Australian entities investing overseas is limited. The rules disallow a deduction for a portion of specified expenses an entity incurs in relation to its debt finance; that is, its debt deductions. The rules apply when the entity’s debt-to-equity ratio exceeds certain limits.
A debt deduction is an expense an entity incurs in connection with a debt interest, such as an interest payment or a loan fee that the entity would otherwise be entitled to claim a deduction for. Certain expenses are excluded from being debt deductions under tax law, including rental expenses on certain leases and some foreign currency losses.
Examples of debt interests include loans, bills of exchange, or a promissory note. Generally, interest free debt does not count as part of an entity’s debt.

While thin capitalisation is hardly ever used to describe property investors, they are generally more highly geared or indebted than most foreign operating entities that gear excessively to minimise Australian tax.
For instance, it is common for a negatively geared investor to have a loan to value ratio (LVR) of 80%. That is, they gear their property investment by 400% (because their debt is four times greater than their equity). The result is that interest payments may exceed property income (rent) and the investor claims a deduction against other assessable income. By reducing their taxation liability, a negatively geared investor places a greater burden on those tax payers that can’t claim deductions. A negative geared investor can defer taxation payments until the property is sold and then they receive favourable capital gains treatment.
The argument to restrict interest deductibility for foreign investors is similar to the argument to restrict interest deductibility for property investors. There seems that a compromise solution can be constructed that limits the amount of interest deductions that an investor can claim as is the proposed thin capitalisation rules. The problem for Australia is that negative gearing has become a crucial ingredient for pushing up residential property prices. Therefore naturally, on taking negative gearing away, it will reduce residential property prices. Negative gearing has contributed to the housing affordability problem in Australia and currently our politicians seem to have no idea what to do to solve the problem.
It is unfortunate that the discussion of the fairness and the ramifications of negative gearing are becoming lost in a sea of political rhetoric and populism. It is in Australia’s interest that a bi-partisan approach is developed to ensure that Australia does not pile on more household debt that reduces taxation revenue and exposes our economy to a potential economic shock when interest rates eventually rise.